CECO: Watch for a sharp drop in Career Education Corp


In 2014, CEC pulled an accounting gimmick in order to remain “financially responsible” in the eyes of the Department of Education (“ED”).

Calculations indicate that CEC’s failure to sell Le Cordon Bleu will result in its Composite Score plunging to below 0.7 – deep into the category of “not financially responsible”.

CEC is already on Heightened Cash Monitoring 1 and is likely to fall into HCM 2, changing its access to almost $700 million in Title IV funds.

CEC has over $70 million in near term off balance sheet lease liabilities and has burned over $50 million over the past year – its cash balance is shrinking quickly.

Separately, CEC is facing more than 2 dozen separate investigations and lawsuits which could potentially result in over $100 million in penalties.

CEC Investment Case – Short

Shares of Career Education Corp (NASDAQ:CECO) are set to decline by around 60% on multiple catalysts.

In 2014, Career Education Corp or “CEC” received $695 million in federal funds via Title IV of the Higher Education Act. Pursuant to the Title IV Program regulations, each eligible higher education institution must, among other things, satisfy a quantitative standard of financial responsibility that is based on a weighted average of three annual testswhich assess the financial condition of the institution.

For each of 2013 and 2014, CEC scored 1.5 out of 3.0, where 1.5 is the bare minimum score to be deemed “financially responsible” and eligible to receive Title IV funds without restriction.

But last year, the only way that CEC was able to maintain this score was by stating its intention to sell its famed (but failing) culinary school, Le Cordon Bleu. It was an accounting gimmick which allowed CEC to shift over $200 million in expenses into discontinued operations.

However, CEC had already been placed on Heightened Cash Management 1 (“HCM1″) due to administrative concerns raised by the Department of Education over misrepresentation of placement rates. The HCM status affects how and when the funds are disbursed.

It appears that recent financial declines, including CEC’s failure to sell its failing Le Cordon Bleu schools, will now result in CEC falling into the lowest possible category of “not financially responsible” and could see the company downgraded to HCM2.

CEC had warned of this possibility in its risk factors in its most recent 10K. The company disclosed the failure of the LCB sale in December 2015. But so far it appears that no one has performed the detailed calculations which reveal that the plunge in its Composite Score has already taken place. The calculation methodology is made public by the Department of Education such that those who care to make the effort can do it themselves before it is disclosed by CEC.

I have performed the calculations and they show that CEC will now fall to a level of 0.646 – well below the 0.90 threshold for “not financially responsible”.

Under HCM2, CEC would no longer receive direct Title IV funds and instead would have to use its own cash to front to students. If this happens, it would be a disaster for CEC and would see enrollments plunge. Again, last year CEC received $695 million (over 90% of its revenues) from Title IV sources.

CEC does not even remotely have the cash to fund such enrollments. CEC appears to have a total of $185 million in unrestricted cash. This equates to around $2.72 per share in cash, which happens to be right where the stock trades. Investors are valuing the ongoing business of CEC at zero.

However, short term off balance sheet lease obligations (within the year) and ongoing cash burn will take net cash down to around $80 million ($1.20 per share) this year.

I expect the stock to trade at around net cash per share at around $1.20. The primary catalyst for the decline in the share price would be the disclosure by CEC that it has been deemed “financially not responsible” by the Department of Education. Additional (secondary) catalysts may come in the form of significant legal settlements from the more than 20 active lawsuits or investigations against CEC.


There was a time when for profit education stocks were a veritable gold mine for investors. Aggressive marketing allowed the companies to grow enrollments at unprecedented rates while Uncle Sam footed the bill through loans and grants.

But now the party is coming to an ugly end.

Shares of Apollo Education (NASDAQ:APOL) are down by nearly 70% this year. Shares of ITT (NYSE:ESI) are down by a similar 70%. But even those are far better off than Corinthian Colleges and Education Management Corp which have basically gone bust (down 99-100%).

Apollo’s University of Phoenix has been placed on probation by the US Department of Defense for various violations. The US Department of Education enacted a rule (the “gainful employment rule“) which could eliminate government funding to hundreds of thousands of students at underachieving for-profit colleges. The FTC, the OIG, the SEC and dozens of state attorneys general are in the process of suing or investigating the for-profit schools for misrepresenting placement rates. The Department of Education has also put forth a “90:10″ rule which eliminates Title IV funding for schools which receive more than 90% of their funding from Title IV sources. This is a direct shot at the for profit sector.

The point is this:

The for-profit education sector has reaped billions of dollars from federal loan and aid programs, even as completion and job placement rates continue to be dismal. Against this, the for-profits have repeatedly been found to use marketing tactics which are overly aggressive and blatantly misleading.

The Feds and the State governments are using a wide variety of legislative tools to clamp down on the abusive nature of the for-profit education sector. We can see from the collapse of Corinthian Colleges and Education Management that the various governments are not pulling any punches and are perhaps even looking for ways to curtail the rapid growth of the for-profit sector which includes shutting these players down altogether.

The focus of this article is on Career Education Corp or “CEC”. CEC shares are already down by more than 60% for the year, but are likely to fall by another 60% due to recent developments.

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As with the other for-profit schools CEC is facing a wave of investigations and lawsuits over deliberate inflation of job placement rates. Only the first of these has been settled and that one already cost over $10 million alone. There are more than 20 remaining active suits and investigations against CEC coming from the FTC, the OIG and more than 20 state governments.

CEC has already disclosed how recent legislative changes have forced it to close dozens of its physical schools. As we will see below, the vice appears to be tightening much more on CEC.

Meanwhile, both the CEO and the CFO recently resigned.

The former CEO was replaced by Todd Nelson who came from both Apollo Education and Education Management Corp. However, Mr. Nelson has a track record which is littered with regulatory problems which resulted in over $100 million in past fines and penalties. The state and federal governments are no doubt very familiar with Mr. Nelson, his companies and their practices.

CEC has a market cap of around $200 million and currently has around $185 million in unrestricted cash (around $2.72 per share) and appears to have no long term debt. Investors appear to be valuing the business itself at zero while naively valuing the stock at what appears to be cash per share.

Unfortunately, the fact is that this apparent cash balance is very misleading. What investors have missed is the fact that CEC has $71 million in short term off balance sheet liabilities this year due to ongoing lease payments (including from schools being shut down, such as LCB). The company has also burned more than $50 million in cash in the past 12 months.

As a result, the real net cash balance for CEC should be viewed at around $80 million, or around $1.20 per share.

This should all become apparent once the next earnings report is released shortly.

In the past, CEC was a successful operator of online as well as brick-and-mortar schools. But the problem is that brick and mortar schools are too expensive to operate compared to online only programs.

As a result, in 2014 CEC completed the shut down of 21 of its then physical campuses. It also created a “transitional group” of 12 more campuses which are to be shut down by 2017.

In September of 2015, CEC completed the “sale” of its Missouri College campus. However, the company received no proceeds from this sale, and in fact it was required to make additional working capital payments to the “buyer” just to complete the supposed “sale”.

As disclosed:

We received no consideration for the sale of Missouri College and recorded a loss on sale of $0.9 million for the quarter ended September 30, 2015. The terms of the agreement provide that we make certain working capital payments to the buyer; accordingly, these amounts were included in the loss calculation.

The point is that CEC literally can’t even give away its assets for free. They have to pay 3rd parties just to give away the assets.

In December of 2015 (4 weeks ago), CEC announced that it had failed to sell its Briarcliff College. As a result, CEC is forced to “teach out” out the remaining programs and record a loss of $6-8 million.

This leaves CEC with its “University Group” (the mostly online programs of Colorado Technical University and American Intercontinental University) and its “Career Colleges Group” (the 5 physical campus schools which offer career training in fields like healthcare and fashion/interior design).

The majority of CEC students fall within the University Group, where it is now the case that around 90% of the students are online only.

The latest of its schools to face a shut down is the famed culinary school Le Cordon Bleu. LCB contributed $173 million of revenue in 2014 but also generated losses of $67 million. As of Q3, CEC management seemed confident that a sale of LCB could be effected, such that the school could keep running for students without saddling the parent company with the huge ongoing losses.

But now it all hits the fan, because in December 2015 it was announcedthat the hoped-for sale had fallen through and that CEC would instead conduct a “teach out” through 2017. A teach out means that CEC will continue to run the school and allow current students to finish their programs, although no new students will be accepted. The additional drag on cash and earnings (losses) is therefore set to continue for at least 2 years going forward.

The failed sale could not have come at a worse time for CEC. The company’s financials have already deteriorated to the point where it will be deemed “financially irresponsible” by the Department of Education (“ED”).

The ED makes public its scoring methodology for schools which wish to participate in the Title IV government funding program which funds student loans and grants.

Here is an example calculation as provided by ED. The purpose is to illustrate the methodology.

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For clarity, the accounting definitions of the terms above are also provided.

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The calculation is somewhat convoluted and involves a number of specified accounting definitions. As a result, it appears that the market has not yet digested the fact that CEC would now be deemed “financially irresponsible” by the ED according to the latest financial numbers.

Once the market figures out this score, the stock price is likely to fall dramatically.

The Composite Scores range from -1.0 to +3.0. A score of 1.5 to 3.0 means “financially responsible” and eligible to receive Title IV funds without restriction. A score of 1.0 to 1.4 means “in the zone” of financial responsibility. “Zone” schools can still participate but may need to post a large letter of credit and adhere to other restrictions. Schools which score below 1.0 are deemed “not financially responsible” and must obtain provisional certification and adhere to certain “cash monitoring” requirements.

Even before the recent problems at CEC and before the failure to sell Le Cordon Bleu, ALL OF CEC’s SCHOOLS had already been placed on Heightened Cash Management 1 status (“HCM1″). But with the recent problems, it is also likely to be downgraded further to HCM2.

There is a big difference between HCM1 and HCM2.

Academic institutions on HCM1 can still draw down from FSA funds to cover disbursements in largely the same way as unrestricted schools. But schools on HCM2 are far more restricted.

According to ED:

A school placed on HCM2 no longer receives funds under the Advance Payment Method. After a school on HCM2 makes disbursements to students from its own institutional funds, a Reimbursement Payment Request must be submitted for those funds to the Department.

This is crucial. A school which is placed on HCM2 must front all of the money itself to students and then try to get reimbursed by the ED after the fact.

HCM2 is a very big deal. Out of the thousands of Title IV schools in the US, only a few dozen are currently on HCM2.

CEC had already warned investors of this possibility in 3Q 2015:

ED may impose monetary or program level sanctions, impose some period of delay in the Company’s receipt of Title IV funds or transfer the Company’s schools to the “reimbursement” or Heightened Cash Monitoring 2 (“HCM2″) methods of payment of Title IV Program funds. While on HCM2 status, an institution must disburse its own funds to students, document the students’ eligibility for Title IV Program funds and comply with certain waiting period requirements before receiving such funds from ED, which results in a significant delay in receiving those funds.

Last year, CEC received $695 million in funds via Title IV out of total revenues of over $741 million.

This would mean that under HCM2, CEC would have to come up with nearly $700 million in cash of its own to front to students before attempting to get reimbursed by ED. But CEC simply doesn’t have the money. Without that funding, enrollments would (by necessity) plunge dramatically.

So just how bad are things at CEC ? Very bad.

In the past, CEC disclosed that it had received a Composite Score of precisely 1.5 in both 2013 and 2014. In other words, CEC was already at the lowest level possible to be considered “financially responsible”. Given the obvious deterioration in CEC’s finances, it should not be surprising that the company has fallen out of the “financially responsible” category.

The timing of last year’s decision to “sell” LCB is notable. By stating just its intention to sell LCB, CEC was able to shift all of the LCB expenses (over $200 million in 2014) into discontinued operations. This was the only way that CEC maintained its score of 1.5 (“financially responsible”).

CEC went to great lengths within its disclosure to describe what would happen if it fell into “the zone” of 1.0-1.4. But the company failed to go into much detail about what would happen if it fell into the lowest category – i.e. below 1.0.

Below are the calculations performed for the last 12 months as of Q3 2015, which show that CEC now earns a score of just 0.646. These are my calculations. For the sake of completeness, I have included as an Appendix the calculations for 2014 and 2015. This just verifies that this methodology does indeed result in scores of 1.5 for both 2013 and 2014, as disclosed by CEC and as calculate by the Department of Education.

Again, the definitions of the accounting terms above (such as adjusted equity, modified equity) can all be found here.

As per the ED, note that the “strength factors” in the calculations are calculated such that they cannot be greater than 3.0 or less than -1.0. As a result, the Net Income factor is the same (-1.0) in all three years. The point is that seasonality from using Q3 numbers does not affect these calculations. Instead, it is the steep plunge in equity that has caused the change.

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Note: the table above calculates the Composite Score for CEC based on LTM numbers from Q3 2015, with the assumption that LCB expenses and revenues are added back in to continuing operations from discontinued operations.

As per the 8K from CEC dated December 11th, 2015:

LCB contributed $128.2 million and $172.6 million of revenue and ($43.5) million and ($66.6) million of operating losses for the nine months ended September 30, 2015 and for the year ended December 31, 2014, respectively. As a result of the decision to teach-out the Le Cordon Bleu campuses, the results of operations for these campuses will now be reported within continuing operations.

A look at the new CEO

One thing should be jumping out at investors by now: the state and federal governments have the for profit institutions in their sites. Government agencies are aggressively implementing new rules which are effectively turning off the federal funding spigot. They are also coming after bad actors with lawsuits and investigations.

Following the resignation of the former CEO and CFO, CEC appointed Todd Nelson as the new CEO in August of 2015. Nelson had previously served as CEO and Chairman of Apollo Education between 2001 and 2006. He then served as Chairman and CEO of Education Management from 2007 until 2013.

During his 13 years with those predecessors, Nelson amassed a track record which involves hundreds of millions worth of fines paid out by Apollo and Education Management.

In 2004 Apollo paid what was at the time the largest settlement of its kind for its actions under Nelson after a review by the U.S. Department of Education.

A government review of the University of Phoenix, the country’s largest for-profit university, paints a picture of a school so hungry to enroll new students that it has threatened and intimidated its recruitment staff in meetings and e-mail, pressured them to enroll unqualified students and covered up its practices to deceive regulators. In a 45-page report obtained by The Arizona Republic, the U.S. Department of Education describes corporate culture overly focused on boosting enrollment. The review, based on site visits and interviews with more than 60 employees and former employees, led to the largest settlement of its kind last week. The Phoenix-based university agreed to pay $9.8 million without admitting any wrongdoing.

Nelson left Apollo in 2006, but even 3 years later in 2009 Apollo was forced to pay $78.5 million to settle Justice Department charges that under Nelson the company had illegally paid recruiters based on the number of students they enrolled.

And then 9 years after his departure, in 2015 Apollo was forced to pay $13.1 million to settle charges that Nelson illegally granted hundreds of millions worth of back-dated stock options that helped him sell $82.8 million worth of stock for himself.

In addition, Apollo faces a string of investigations and lawsuits over deceptive marketing and false claims which went on during Nelson’s tenure.

Apollo looks like it is going to survive (for now). But things are much worse for Nelson’s former company Education Management.

In 2015, Education Management agreed to pay $103 million in debt forgiveness to over 80,000 former students to settle charges brought by 39 state attorneys’ general for practices under Nelson. The wide-ranging charges related to recruiting practices, false and misleading graduate placement statistics, graduate certification and licensing, and student lending activities.

In 2014, Education Management settled with San Francisco for $4.4 million for illegal marketing practices under Nelson at its Argosy art school.

In 2013, Education Management settled with Colorado’s attorney general for lying under Nelson that the company was seeking to have Argosy’s psychology program accredited by the American Psychological Association. It also misleadingly told psychology students that upon graduation they would be eligible to become licensed psychologists, which was unlikely.

In 2011 the Justice Department and five states sued Education Management under Nelson for lying to regulators regarding illegal incentive-based payments to recruiters based on the number of students they recruited.

What does this have to do with CEC ?

The regulators and investigators are no doubt familiar with Todd Nelson. Organizations under his command have already been forced to pay hundreds of millions in penalties for improper actions. Now he is simply sitting atop a new organization with a litany of legal problems stemming from bad behavior.

CEC’s most recent legal problem comes from a Civil Investigative Demand from the FTC which the company received in August of 2015. The investigation regards deceptive marketing or advertising, just like the ones that took down Education Management with its $103 million payout.

CEC is still under investigation by the Department of Education regarding inflation of placement rate reporting.

CEC is also under investigation by the OIG regarding its proper or improper administration of Title IV funds, including how it handles payments with student withdrawals, how it documents attendance with online classes and how it processes refunds.

CEC also faces multiple suits under the Federal False Claims Act which state that CEC provided false certifications to the Federal government, causing the Federal government to make improper payments. The suits each seek treble damages.

Most importantly, CEC faces lawsuits and investigations from 20 different states’ attorneys general regarding recruitment, placement stats and certifications. This is almost identical to what we saw with Education Management with its $103 million settlement.

Education Management now trades for just 7 cents on almost no volume.

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For the past two years, CEC was just barely able to remain “financially responsible” (a score of 1.5 or above) in the eyes of the Department of Education. Last year, this was only achieved by CEC stating its intention to sell its Le Cordon Bleu.

However, CEC has consistently demonstrated that it is unable to sell any of its schools. In fact, it has had to pay money just to give the schools away. Not surprisingly, the supposed sale of LCB fell through. This means that over $200 million of expenses will come back into continuing operations, which has a heavy impact on CEC’s Composite Score with the Department of Education.

Losses have continued to mount, while CEC’s cash balance has continued to shrink.

According to the methodology provided by the Department of Education, the failure to sell LCB combined with ongoing deteriorating financial results as of Q3 would now result in a composite score of well below 0.90. In other words, CEC would now be categorized as “not financially responsible” – by a wide margin.

CEC has already been placed on Heightened Cash Management 1 (“HCM1″) status for “administrative reasons”. Because of the “not financially responsible” designation, the Department of Education would now have ample justification to classify CEC as HCM2. If CEC falls into HCM2, it would no longer receive Title IV funds in advance. Instead it would need to front up to $700 million of cash which it does not have.

CEC’s cash balance is being rapidly consumed by over $70 million in short term off balance sheet lease obligations (due within the year) as well as over $50 million in cash burn over the past year.

Separately, CEC faces dozens of investigations and lawsuits. The first of these alone was settled for over $10 million. CEC’s new CEO, Todd Nelson, presided over two competitors who paid hundreds of millions in penalties for their actions during his tenure. The regulators are no strangers to the CEO and haven’t been shy about handing down massive penalties.

Appendix Composite Scores for 2013 and 2014

(As per the Department of Education, numbers are rounded to the nearest decimal point).

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(Rounded up to 1.50 as per ED guidelines)

Osiris: Aggressive Channel Stuffing, Accounting Irregularities, or Outright Fraud ?


  • Aggressive channel stuffing resulting in inflated revenues is now becoming obvious – but is about to end.
  • Past analysis has focused on multiple “accounting irregularities”, new information raises questions of outright fraud.
  • Recorded statements from the CEO may prove to be the “smoking gun” which led to an auditor resignation.
  • Osiris has now just lost its largest customer, which was bought by competitor MiMedx.
  • I expect the stock to trade to around $2-3, down 70-80% based on either substantial restatements or an auditor resignation.

Company summary

Company: Osiris Therapeutics (NASDAQ:OSIR)

Share price: $8.50

Cash/Share: $1.23

Market Cap: $300 million

LTM Rev: $88 million

LTM Net Income: $1.9 million

P/E ratio: 175x

Author’s note on use of the word “fraud”

As of this writing, I currently have over 3,200 followers on Seeking Alpha. These readers have no doubt come to realize that I tend to cover shorting opportunities where companies are doing something wrong. I do not simply focus on overvalued stocks. But readers should also be aware that I very seldom ever use the word “fraud” even when there are many red flags which might otherwise justify such use. I am very careful with using the word “fraud”.

The last time I came out and used the word “fraud” was when I wrote about Forcefield Energy (NASDAQ:FNRG). The stock had been trading at around $7.80, but cratered by nearly 30% on the day of my article. This prompted the company to issue a forceful response against me. The company promised a full business update and rebuttal for the following Monday. By Monday, the stock was down by a full 60% and the only update the company could provide was that the chairman of Forcefield had been arrested by the FBI at the airport in Miami while trying to flee the country. The stock was immediately halted. It has since resumed trading at around 1-2 cents. Down 99%.

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Even while the stock was halted, we can see that there were numerous retail investors posting comments in support of Forcefield at the bottom of my article. Those investors would have clearly lost around 99% of their money by refusing to get out of an obvious fraud.

I would strongly encourage readers of this article to read those positive comments at the bottom of my article on Forcefield. I expect to see similar positive comments on Osiris. I also expect that those who are still supporting Osiris in the face of very obvious problems are about to be sorely disappointed

There are two points to be made here. First, I only use the word “fraud” when I see something egregiously wrong with a company. Second, when a fraud comes unraveled, the implosion is often swift and brutal and provides little to no opportunity to get out. With thousands of other stocks to own out there, there is simply no reason to hold on to a stock that has even a hint of fraud about it.

Background on Osiris Therapeutics

There are many existing red flags on Osiris. The CFO has already resignedand been replaced. The auditor (BDO) has also resigned and been replaced. Internal accounting controls have already been deemed to be ineffective. Research analysts have switched from “buy” to “sell”. The company’s receivables DSO (“Days Sales Outstanding”) balance has exploded to over 130 days, despite assurances from the company that it should be declining. There are blatant inconsistencies between various SEC filings, as well as inconsistencies between statements made by management and information contained in filings. These appear to have led to the auditor resignation. We can also see that Osiris’ largest competitor is publicly calling into question the supposed revenues being generated by Osiris using independent market data.

Former auditor BDO first required multiple restatements of past financials due to improper recognition of revenue. The auditor then took the highly unusual step of requiring Osiris to begin recognizing certain revenues on a “cash basis“, only once actual cash had been received. Osiris’ newly appointed CFO assured us that the damage was done and there would be no more issues. Shortly thereafter, auditor BDO resigned altogether. Osiris didn’t disclose the resignation of its auditor for a full week, and then only disclosed the resignation once a new auditor had been appointed. This limited the damage to the stock price.

But prior to the resignation, the auditor also required some new disclosure:

On occasion, customers purchase product and request that the Company store the purchased product in segregated freezers at the Company’s facility.

In other words, the supposedly “sold” product is not even being delivered to the customer

Moreover, we know from the company’s receivables disclosure that most of the product is sold on very generous extended payment terms.

So what the disclosure above means is this: in certain circumstances, no product changes hands AND no money changes hands, yet Osiris still recognizes revenues from supposed product sales.

Such an arrangement is downright absurd. Osiris is merely manufacturing revenues when no sales are actually occurring in reality.

The tip off about these irregularities is that Osiris’ DSO balance now exceeds 130 days. This is more than double the average of competitors and is well in excess of what even Osiris itself considers to be delinquent payment by its customers. Osiris discloses that payments which are due more than 45 days are considered delinquent. So it is safe to say that the majority of receivables are delinquent.

If we had no more information than that above, Osiris would be a very attractive short candidate. Osiris has appointed Big 4 auditor E&Y in an attempt to instil confidence with investors. But as we have seen in the past (examples provided below), when troubled companies appoint Big 4 auditors, these auditors are even more likely to uncover problems, and are just as quick to resign. Based on the analysis below, I see very little chance that Osiris will be able to issue its annual 10K filing. I fully expect E&Y to become aware of the problems below and to resign before the annual report is due. Or at a minimum, there will be further substantial restatements.

Osiris has $43 million in cash (about $1.23 per share) and does generate some revenue (but almost no profit). As a result, the stock is not likely to be a true “zero”. Instead we should expect the stock to trade at around $2-3 based on restatements or auditor resignation.

What does Osiris do ?

Osiris produces three types of human tissue products. The company’s main product is Grafix, which is basically frozen tissue derived from donated human placentas. The product is used for wound care, including burns and diabetic foot ulcers. Osiris does not disclose the breakdown of its product sales, but analysts estimate that 90-95% of revenues come from the sale of Grafix alone.

Osiris also produces a cartilage allograft known as Cartiform, which accounts for minimal sales.

Finally, the company produces a bone allograft which is currently known as BIO4. The bone allograft was originally produced using placental membranes and was known as Ovation. But the FDA ruled against the production of Ovation and required Osiris to stop producing and marketing the product. Rather than destroy the remaining inventory, Osiris took a very unusual step. Osiris handed all remaining inventory to several distributors and told them to simply pay for it once they could eventually sell it. So even though the FDA ruled against it, Osiris found a way to keep selling the product.

Since that time, Osiris has made substantial changes to the bone allograft product. It is now made from bone tissue rather than from placental tissue. The new product is known as BIO4.

A closer look at Stability Biologics

As part of my due diligence, I began identifying and contacting multiple distributors who do business with Osiris. The largest of these is Stability Biologics. As will be shown below, there is considerable uncertainty as to just how much business Stability actually does with Osiris. This is due to blatant inconsistencies within Osiris’ SEC filings.

But in any event, Stability was most recently listed in the 10Q as being responsible for 11% of Osiris’ revenues. And we can see that Stability was just bought by MiMedx, creating a gaping revenue hole for Osiris.

It also means that the past channel stuffing must now come to an abrupt end, with revenues set for a steep drop.

We know that Stability was Osiris’ largest customer because it is the only one that Osiris discloses in its SEC filings. But we quickly run into problems quantifying it. This is because the SEC filings from quarter to quarter provide wildly differing numbers - even for the identical quarters.

In Q1 of 2014, Osiris claimed that Stability accounted for fully 58% of its revenues that quarter. But if we then look at the 10Q for 2015 (which shows revenues from Q1 2015 and Q12014) we can see that Osiris now says that in Q1 of 2014 (i.e. the same exact quarter), Stability only accounted for 15% of revenues.

Here is the text from each 10Q:

From the 1Q2014 10Q (page 10):

During the first fiscal quarters of fiscal 2014 and 2013, revenues from one of the distributors of our Biosurgery products, Stability Biologics, comprised approximately 58% and 64%, respectively, of our total Biosurgery product revenues.

From the 1Q2015 10Q (page 11):

During the first fiscal quarters of fiscal 2015 and 2014, revenues from one of the distributors of our Biosurgery products, Stability Biologics, comprised approximately 13% and 15%, respectively, of our total Biosurgery product revenues.

Something is clearly very wrong with the sales that supposedly went to Stability. This is most likely one of the factors which led to the resignation by BDO.

Why did auditor BDO resign from Osiris ?

Concurrent with the release of its 3Q2015 financials, Osiris announced that it was restating past financial results for multiple quarters because there was

lack of sufficient evidence of the contractual arrangements to satisfy the applicable auditing standards, which is necessary to recognize revenue on an accrual basis under GAAP.

In short, Osiris was improperly recognizing revenues. Simple as that.

On the quarterly conference call, Piper analyst Ted Tenthoff asked:

should we anticipate any other changes during the quarter or does this pretty much bring this issue to a close

New CFO Greg Law responded that:

It’s bringing the issue to a close

While CEO Dr. Lode Debrabandere stated that:

Remember Ted that we absolutely discontinue duration in 2014, so that will cost a very, very vast kind of sound observation and so that makes it all come to a closure and be done with it.

But it wasn’t done. Not by any means. In fact, things were about to get much worse.

Just a few days later, Osiris released an 8K noting that auditor BDO had now deemed its internal controls to be ineffective. Details of this change were analyzed by author Edward Vranic in his own article.

As of this time, BDO was continuing to raise serious concerns but had not yet resigned.

But then the company presented at a Canaccord conference and was questioned by several audience members on receivables. The audio for this conference can be found here.

First, new CFO Greg Law sought to reassure the conference that there would be no more restatements, stating:

So are we done ? I believe we are done.

But it was the statements made by the CEO (at approximately 8:50 into the audio) that likely led to the swift resignation of auditor BDO.

In response to a question on receivables, CEO Dr. Lode Debrabandere stated that:

For example, PhysioRX, we have publicly stated that we booked $1.1 million in the fourth quarter of 2014. Of that, $1.1 million, $800,000 has been received already in cash, and the remaining $300,000 is expected before this year end. So, that is pretty much done. There is still a $0.7 million order out there of PhysioRx from the first quarter. And then there is the Stability acquisition of Ovation from the 4th quarter of 2014 that makes up to the about $7 million total.

These comments are crucial and are most likely what led to the resignation of auditor BDO.

So what the CEO is telling us is that there is about $1 million of receivables coming in from PhysioRx and at least $6 million coming in from Stability.

But we can see from the most recent 10Q that Stability only accounts for 2% of accounts receivable, just $757,000. So what Osiris has already disclosed to investors ($757,000) is nowhere near the level which is being stated by the CEO (at least $6 million).

These amounts come from a single distributor and amount to at least 10% of the revenue which Osiris reported to date in 2015.

The statements regarding Stability are wildly at odds with what Osiris discloses in its SEC filings. Within a few days of these statements from the CEO, auditor BDO suddenly resigned. (Despite the repeated assurances from the CEO and CFO that we were “done” with accounting issues.)

Appointing a new auditor

When a troubled company appoints a Big 4 auditor, it should actually be viewed as more cause for concern than cause for relief. We have seen this consistently around the world in China, the US and Japan.

Back in 2010 and 2011, there was a wave of auditor resignations among US listed Chinese companies. Even the companies which had not yet faced an auditor resignation still faced a crisis of confidence and plunging share prices.

As a result, a number of these companies sought to reassure investors by appointing Big 4 auditors. The ruse worked for a few months and the share prices soared – even though a number of these companies were entirely fraudulent.

But what happened was that ultimately the Big 4 auditors were even more stringent that their smaller predecessors and when it came time to put out a 10K, the Big 4 auditors found even more problems and simply refused to sign off.

We saw this repeatedly on Chinese companies including Wonder Automotive (formerly WATG) where newly appointed PWC resigned,Subaye (formerly SBAY) where newly appointed PWC resigned andDuoyuan Printing (formerly DYP) where newly appointed Deloitte resigned.

We have also seen similar “upgrades” followed by auditor resignations with US companies. This includes EBIX and Advanced Emissions which upgraded to KPMG only to have them resign. We saw the same thing with Nature’s Sunshine in the US when E&Y resigned.

In Japan we saw the same with Olympus and Toshiba in the wake of their fraud scandals.

The point is that former auditor BDO suddenly found ample problems to justifying resigning. A Big 4 auditor is almost certain to find all of these problems, and possibly more, prior to the release of a 10K.

The outcomes I expect from here are either that E&Y will simply resign, or they will again require massive restatements due to the inconsistencies described above.

Third party accusations of fraud ?

The fundamental questions to the fraud thesis are: is Osiris overstating revenues ? If so, by how much ?

It is unusual that Osiris does not disclose any breakdown of revenues between its products. However, analysts estimate that 90-95% of revenues come from the Grafix product alone. It is almost everything.

The main competitor and market leader in the wound care space is MiMedx (NASDAQ:MDXG). MiMedx has already come out in two public statements formally stating that Osiris is overstating its revenues.

From the MiMedx Q3 conference call:

Generally speaking, we find our data to be reasonably accurate with occasional acceptance for some companies that do not publicly disclose the product line breakouts. For example, we’ve analyzed the Medicare 2014 claims data for the hospital outpatient market. This data shows that in 2014, MiMedx had the market leadership position with 34%, Organogenesis was next at 31% and Osiris was at just under 8%.

Now this Medicare data tells us that the SmartTrack data for MiMedx and Organogenesis are reasonably consistent with the Medicare data. With the SmartTrack, Osiris data is very likely significantly overstated. Our SmartTrack data shows Osiris at about half or 50% of our wound care revenues. The sales in the category are most likely closer to 20% of ours in wound care based on the calculations from the Medicare data.

Separately, in a recent letter to shareholders, MiMedx stated the following:

We have previously presented the Medicare and commercial payer data on the Grafix product as well as other competitors. Osiris has refused to give its shareholders any revenue breakdown. They like to create the myth that their revenue is largely competitive with our EpiFix product in the advanced wound care sector. That is not the case. There is information from Medicare, the Veterans Administration and from commercial payers showing that Grafix revenues are approximately 20% of our EpiFix revenues.

How can these discrepancies be explained ? It is simple. Osiris is recognizing revenues in exchange for receivables. The products simply sit at the distributors and are never being sold to the end market. And unfortunately Osiris is never getting paid. We can see this from the DSO balance which now exceeds 130 days.

But now that Osiris’ largest customer has been sold to Osiris’ largest competitor, the scheme must come unraveled and reported revenues will plunge.

Conclusion: What is Osiris doing wrong ?

Osiris has consistently been improperly recognizing revenues. That much should be clear. This has inflated both the absolute dollar about of revenues as well as the perceived growth rate.

Osiris has only begun to get caught. Before resigning, former auditor BDO required restatement of 3 quarters of revenues for PhysioRx, and required PhysioRx to be treated on a cash only basis.

But PhysioRx has always been a tiny customer, accounting for roughly $1 million in any disclosed quarter.

Stability Bio is a much bigger deal. It is likely the problems with Stability that resulted in the auditor’s resignation. This can be gleaned from the timing of the resignation vs. the comments made to audience members at Canaccord.

We know that Stability was a major customer, but many of the disclosures which quantify this are contradictory. This is a major problem.

At one point, Osiris disclosed that Stability was responsible for 58% of revenues in Q1 of 2014. Later, Osiris stated that it was just 15% of revenues in that same quarter. The difference is clearly massive and yet no explanation or reconciliation has been provided.

Separately, at a recent conference, the CEO stated that Stability was responsible for around $6 million of receivables owed to Osiris. Yet the most recent 10Q puts that amount at just $757,000. It should be viewed as telling that the auditor resigned shortly after these statements were made.

Auditor BDO resigned on December 11th. However, Osiris deliberately did not notify investors of the resignation until 1 week later, once it had already appointed a new auditor, the Big 4 E&Y. But given Osiris’ past troubles, investors should be feeling more concern rather than comfort over the appointment of E&Y. E&Y is virtually certain to encounter the same issues that led to BDO’s resignation as well as additional issues regarding receivables.

Competitor MiMedx has repeatedly cited Medicare and VA data, accusing Osiris of overstating revenues by 2-3x. What is most likely happening here is that Osiris is offloading inventory onto various distributors (including Stability). This inventory is never sold, resulting in the exploding receivable balance at Osiris. But Osiris still books the sales anyway, inflating revenues.

Osiris is still valued at around $300 million, despite the fact that it struggles to achieve any profitability. An auditor resignation or massive restatement is highly likely, which would send the stock to around $2-3 in short order.






The author was previously an investment banker for a major global investment bank and was engaged in investment banking transactions with a wide range of healthcare companies including medical device, pharmaceutical, genomics and biotech companies. The author has not been engaged in any investment banking transactions with US listed companies during the past 5 years. The author is not a registered financial advisor and does not purport to provide investment advice regarding decisions to buy, sell or hold any security. The author currently holds a short interest in OSIR and during the past 12 months has shared his fundamental and/or technical research with investors who hold a short position in the stock. The author may choose to transact in securities of one or more companies mentioned within this article within the next 72 hours. Before making any decision to buy, sell or hold any security mentioned in this article, investors should consult with their financial adviser. The author has relied upon publicly available information gathered from sources, which are believed to be reliable and has included links to various sources of information within this article. However, while the author believes these sources to be reliable, the author provides no guarantee either expressly or implied


How Revance Is Misleading Investors About RT002


Revance has soared 50% to all time highs based on preliminary data from a Phase 2 study which appeared to indicate that its RT002 was superior to Allergan’s Botox.

Revance has deliberately shown misleading data and withheld the real information which would actually be required for FDA approval.

The CMO quit one day after the data was released and Revance suddenly announced that in Phase 3 it would no longer be comparing to Botox at all.

For reference, Valeant sold 5 drugs including competing product Dysport to Galderma for just $1.4 billion – indicating that Revance is wildly overvalued.

With no revenues, expect near term downside of 50% or more.

Company stats

Name: Revance Therapeutics (NASDAQ:RVNC)

Product: ”improved” Botox products

Market Cap: $1.1 billion

Avg. Volume: 529,000 shares (approx.. $20-25 million /day)

Share price: $36.43

Cash / share: $9.64

LTM revenue: (none. Pre revenue)

Just prior to the recent share price spike Revance filed an S3 registration statement allowing the sale of 8.4 million shares by restricted major shareholders.

(click to enlarge)


When I first heard about Revance Therapeutics in 2014 I was convinced that it would be a compelling long pick based on its story. Revance is best known for its product in development RT001, a “topical” botulinum toxin (i.e. Botox) gel which can be applied directly to the skin with no injections. But the company is also developing an injectable RT002 which is intended to be a longer lasting version of the botulinum toxin injection, hopefully lasting about 2 months longer than Allergan’s Botox.

Upon closer analysis of recent events (and due to the recent share price spike), it has become clear that Revance is in reality a truly compelling short candidate.

Given that the company has zero revenues and its first product is at least 3 years from being on the market (and even that subject to ultimate approval), it is hard to quantify how low the stock could fall. But based on the information below, a drop of 50% or more should be expected.

For reference, Revance went public at $16.00 per share. After hitting $38 in 2014, the stock cratered back to $15.00 when its RT001 failed a Phase 2 study.

The “story concept” of Revance focuses on RT001, which is the topical gel. It is a novel concept, but even the clinical trials for RT001 are suggesting that it could still be largely inferior to traditional Botox. RT001 is currently being studied in a Phase 2 trial for use in hyperhidrosis (excessive sweating), but it is only being tested in a handful of patients to see if it works for a mere 4 weeks.

That is the hope. But it needs to be remembered that traditional Botox works for as long as 9 months. Revance also recently launched a Phase 3 trial for RT001 for “crows feet” wrinkles, but results for that will not be in for at least a year. In these other applications, many are doubtful that it will ever be possible for a large molecule protein to be effectively absorbed through the skin. But again, that is the hope. It should be remembered that Medicis Pharmaceutical (later acquired by Valeant) had an option to license RT001 for just $94 million (including all milestones but not royalties), but Medicis walked away, apparently deciding that RT001 did not have that much promise. Medicis’ last 10Q can be found here.

The point is that it is NOT the RT001 topical gel concept that has been driving the stock. Instead it is the injectable RT002. It was the presentation in October by Revance management of interim Phase 2 data on RT002 that sent the stock soaring recently.

The whole point of RT002 is that it is intended to be better than traditional injectable Botox. It is hoped to deliver an identical result, but last two months longer. The comparison to Botox is entire point of the Phase 2 “Belmont” study.

Prior to the release of partial data for its Phase 2 trial on RT002, the stock had been trading at around $26.00. Following management’s presentation of that data (the Belmont study), the stock quickly soared by 50% to over $40.00. The conclusion presented by management was that RT002 was superior to Botox across the board.

This is important for two reasons. First, management has hidden or misrepresented the key data needed to evaluate the prospects for RT002. This is what caused the stock to soar. Second, the valuation for Revance as a company (even if we assume ultimate approval !) now visibly exceeds what it should be worth in the market. This is explained below.

POINT #1: A brief word of common sense

Valuation alone is never a sufficient reason to get short a stock. Overvalued stocks can stay overvalued for a long time. But when gross overvaluation is combined with underlying fundamental problems, it creates the setup for compelling short trades.

This was the case when I wrote about Keryx Biopharm (NASDAQ:KERX) earlier this year. Even though the stock was hitting new lows of $10.00, the stock was still grossly overvalued at $1 billion market cap and had visible underlying fundamental problems. That stock has since fallen to as low as $3.00 and now trades for around $5.00. Downside of 50-70% since I wrote about it.

Not surprisingly, there were no shortage of sell side analysts pitching Keryx as a compelling long trade with massive supposed “upside”. With a high valuation and with minimal revenues, Keryx made an ideal potential client for fee hungry investment banks. The wildly bullish price targets followed accordingly.

Likewise, Revance is already trading at a spectacular valuation but several small investment banks (William Blair, Cowen and Piper) are pounding the table telling us to expect even more upside. With no revenues and no potential products on the market for years to come, Revance is the ultimate investment banking client, so this support should come as no surprise.

But as we will see below (as just as we saw with Keryx), there is likely at least 50% downside in Revance from here.

Here’s the rub.

The market for Botox and its competitors is a $3 billion a year industry. There are currently 4 approved players in this market, all with a highly similar offering. The best known is Botox / Botox Cosmetic which is marketed by Allergan. There is also Myobloc marketed by US World Meds. Then there is Xeomin, marketed by Merz.

Last there is Dysport, which (just like RT002) is intended for cervical dystonia and glabellar lines. Dysport is important because it was sold as part of a package by Valeant to Galderma in 2014. Article. The total package included 5 other marketed drugs (Restylane, Perlane, Emervel, Sculptra and Dysport).

The total purchase price for ALL of these FDA approved products to Galderma was just $1.4 billion. Restylane alone had $360 million in global sales in 2013. It was a sizeable drug. So Dysport alone might have accounted for around half of that $1.4 billion value or less. That is around $700 million for an APPROVED botulinum toxin treatment ALREADY ON THE MARKET.

Yet at current prices Revance alone (prior to approval of ANY products) is already valued at $1.1 billion.

Even according to its own time line, if everything goes as planned, Revance won’t have any product on the market for at least 3 more years (2018). And of course ultimate approval is not guaranteed.

This alone sets up Revance to be a good valuation short at current prices. Its value already well exceeds what already APPROVED competitors have gone for as recently as last year.

But aside from just the valuation there are also more important fundamental points to be made.

POINT #2: What happened to the missing 77 patients ?

A cursory read of the Revance Belmont presentation on the Phase 2 results for RT002 appears to be compelling. RT002 appears to be better than Allergan’s Botox across the board.

The problem is that management is misrepresenting the data and playing games with the numbers. Without such game playing, we have zero indication that RT002 has any benefit over Botox. If that is the case, then the downside in the stock is immense.

First off, in showing efficacy, Revance has withheld 77 patients who were involved in the study. Their results were included in the safety numbers, but then omitted when looking at efficacy.

This can be seen by a closer read of the presentation.

The study was divided into 5 populations. There was a placebo arm, a Botox arm and three arms for different doses of RT002.

On the slide dealing with safety, management reports results for 268 patients in total, roughly 53-54 in each arm. (See N=53,54 at top row in yellow).

(click to enlarge)

But when we get to the supposedly compelling data on efficacy, there are 77 patients missing from the results. Notice that the N changes down to a range of 34-42 in the top row.

(click to enlarge)

These patients were given the product and had some result (either satisfactory or not). With 29% of the patients missing from the actual data, we have no idea what the actual results are.

But actually the problems get much worse.

POINT #3: Revance has presented misleading efficacy data regarding RT002

In 2014, the FDA put out a document entitled Guidance For Industry: Upper Facial Lines: Developing Botulinum Toxin Drug Products. The document spells out clearly what is required in getting botulinum toxin drugs approved for facial lines.

The improvement in the appearance of wrinkles is scored in points on a 4 point scale. No wrinkles is 0, mild wrinkles is 1, moderate wrinkles is 2 and severe is 3. Most patients would start at a level of 2 or 3. This is a key reason why the FDA demands a two grade improvement. A patient who starts at a grade of 2 and improves to a grade of 1 has sustained an improvement that could also be considered “noise”. That is why the FDA demands a score of 0 or 1 AND a 2 grade improvement.

On line 364 of that FDA document, we can see clearly that:

Success should be defined as achievement of a score of 0 or 1 ANDtwo-grade improvement from the baseline, on both the IA and the SSA scales concurrently, to ensure clinical significance. Because it may be possible to move to an adjacent category on the assessment scale with only a small level of improvement, a one-grade change may not represent a clinically meaningful intrasubject change.

Note from the above that a “one grade change” does NOT count for significance because it is simply too easy to end up moving to an adjacent category.

We know that Revance would have definitely measured the two grade changes in this study. Yet in its presentation to investors, Revance only included the “one grade” change in the following graph.

More so than any other slide in this presentation, this graph caused the massive jump in the share price. The graph is basically saying “this is how much better we are than Botox”. This is very important.

The graph shows the duration and the decay in the results of RT002 vs. Botox vs. a placebo. Clearly the placebo had no effect (bottom line). And just as clearly the green line of RT002 is above the orange Botox line at all levels.

(click to enlarge)

Yet this is a graph measuring changes of 1 point or more wrinkle improvement. Basically, (according to the FDA) this data is meaningless differentiation because a 1 point change does not matter for FDA approval.

So to be clear, Revance has shown us data which makes RT002 appear favorable to Botox, but has deliberately withheld the actual data which was measured and which would be evaluated by the FDA.

We can be sure of one thing: if RT002 had shown a meaningful improvement at the 2 point level, it would have certainly been shown as a graph. In fact, on slide 8 of the presentation Revance shows some 2 point changes – but only at 4 weeks, which is less than time period than Botox is effective.

So the data we have been given is totally irrelevant according to the FDA.

I am quite certain that the people bidding up the stock are not aware of the FDA’s guidelines on wrinkle scoring as it applies to getting FDA approval. If they were, then they would certainly not be bidding up the stock at all based on that graph.

(As we will see below, following the presentation of this “compelling” data, Revance suddenly announced that in Phase 3 it would no longer be comparing RT002 to Botox at all, and instead would be comparing to just a placebo. This should be highly concerning to anyone bidding up the stock).

POINT #4: Missing patient data

Also in the document above, it is clear that the evaluation of wrinkle improvement needs to be based on BOTH the assessment of the clinician as well as on the observation of the patient. In other words, measured patient satisfaction is a required criteria for FDA approval. Yet again, this key piece of FDA approval data has been omitted in comparing RT002 to Botox. And again, if the data were favorable, then we can be sure it would have been included.

It is important to note that if Botox and RT002 received even equal patient satisfaction scores, then that would be deemed a failure for RT002 for lack of differentiation vs. Botox. After all, the differentiation vs. Botox is what this study was supposed to be all about.

If Revance had reported patient satisfaction numbers which indicated that RT002 was equal to Botox, then that would be a failed study and the stock would not have budged.

In any event, patient data is key to FDA approval. And that data was omitted the Revance presentation which caused a 50% jump in the stock. As we will see below, the medical review for Allergan’s Botox clearly includes this data.

It should be considered very likely that RT002 and Botox BOTH had very high patient satisfaction scores. In other words, RT002 would likely have been no better than Botox which would have indicated a FAILED study.

POINT #5: Omitting baseline characteristics

A third omission by Revance was the omission of the baseline characteristics of the patient populations. For example, it is well known that men are less responsive to botulinum toxin treatments than women. Age is also an important factor because it determines underlying skin resiliency. Whether a patient has received Botox in the past also matters. Yet we are given no data on the comparative populations. To the extent that there was any skew in the age or the gender between sample groups, then the data become even more meaningless. Including the baseline characteristics is just common sense in any such presentation. The lack of such data should be very noticeable.

We can see this by looking at data on Allergan’s Botox.

POINT #6: Comparing Revance’s data to Allergan’s data

The best way to illustrate how glaring these omissions are is to look at the medical review for Allergan’s Botox.

Even looking at just one single table provides a wealth of information in the Allergan medical review, even as this data was all omitted in Revance’s presentation.

(click to enlarge)

The graphic above was taken from Allergan’s medical review for Botox. There are 3 points to note. First, because the FDA requires SUBJECT (ie. Patient) assessments (not just the clinician’s) this is obviously a subject assessment table. It is basically a measure of patient satisfaction. Remember that Revance did not provide any subject assessment data.

Second, in contrast to Revance, this table is measuring 2 point movesin wrinkle scores. Again, this is included because this is explicitly what is required by the FDA for approval. Remember that Revance only disclosed data for moves of 1 point or more for data points beyond 4 weeks.

Third, there is a breakdown of results by gender for the 315 women and 58 men.

(And perhaps a fourth point to notice is the considerable difference in efficacy in men vs. women in the data above. That’s why this table is important to include in the first place).

Viewing the information above clearly makes the omissions and misrepresentations from Revance glaring.

If this is not immediately clear, then readers should re-read the section above and then re-read Revance’s Belmont presentation.

POINT #7: Reading “between the lines”

Again, the omissions and misrepresentations should now be seen as entirely glaring. Based on the data provided, there can be very little certainty that RT002 is in fact superior to Botox at all. Even if RT002 were a great product and was equivalent to Botox, this would be a FAILED study because the whole point was to demonstrate superiority to Botox. If this is the case, then the downside in the stock is now immense.

And now we can see that the plot thickens. A lot.

First, just one day after the Revance data was presented, Revance’s Chief Medical Officer (also a co-founder) suddenlyquit the firm. In order to entice him to stay on for two more months, the firm then offered him accelerated vesting on his options. This can be found in the subsequent 10Q filing. Readers should ask themselves why the CMO would suddenly quit if RT002 was such a success and with the stock at an all time high. One does not need to be too cynical to come to the conclusion that the timing of his departure, right after the Belmont presentation, is not a coincidence.

Second, (it gets worse) Revance announced that in its Phase 3 trial, it would no longer be running a comparative study of RT002 vs. Botox at all.

Instead, it would only be comparing vs. a placebo. Now that you can see the gross deficiencies of the data provided by Revance, this development should in fact come as no surprise. Phase 3 trials are much more rigorous that Phase 2 trials and if the ultimate data showed no relative superiority of RT002 vs. Botox, then it would be a major negative for RT002. As a result, Revance has simply opted to decline to compare to Botox in Phase 3 at all.

Thirdjust one week after the data, the company was quick toissue $126 million worth of stock - even though they had $141 million in the bank already. In March, Revance had disclosed in the 10Kthat it has ample funds to get through the next year without raising money. The equity offering was completed at $36.00.

To be clear, Revance did not need the money. Instead, they simply took advantage of the all time high stock price which resulted from the misleading presentation of data. Revance now has around $9 per share in cash (and no revenues). This provides virtually no cushion for the share price.

Each of these factors is a clear indication of what management is trying to hide: the “better Botox” is not what it seems.

The fact that Revance will not be comparing to Botox in Phase 3 is of critical importance for 2 reasons. First, it sheds light on the misrepresentations from the previous presentation. After all, if the data were in fact so compelling in Phase 2, then why not confirm it in Phase 3. But of greater importance is that fact that without a comparative study in Phase 3, Revance will never even be able to market the drug as an improved version of Botox. It basically loses all marketing ability to differentiate itself. And that is the only selling point for RT002. This is of critical importance.


Revance is currently developing two products and is best known for its concept RT001, a Botox-like “gel” which can hopefully be applied topically without needles. But RT001 is not what has been driving the stock higher. Medicis walked away from RT001 suggesting that it may not be the product Revance suggests.

Shares of Revance soared by more than 50% following the release of interim “data” by the company in its Belmont presentation on RT002, the injectable product. The reason for this share price spike is that Revance portrayed its RT002 as being categorically superior to Botox.

But we can see a host of misrepresentations and omissions by Revance that cast massive doubt on this conclusion. The share price should not have budged from $26.00 based on this presentation at all.

Dozens of patients were omitted from the efficacy study. We don’t know which ones or why or what their impact is on the efficacy data.

In convincing investors that RT002 was superior to Botox (via a graph), the company deliberately included wrinkle improvement of 1 point or more, rather than using the 2 point criteria which is required by the FDA. The FDA has already specifically declared that 1 point moves are irrelevant.

Revance would clearly have measured the number of 2 point moves, but the have withheld this data in the only place that it matters. This strongly indicates that the real data is not favorable for RT002.

Also required by the FDA are patient satisfaction scores. And Revance certainly obtained these scores in the study. Yet Revance has also withheld this data from investors. Again, even if the patient satisfaction results between the two arms were merely similar, it would be massively detrimental to Revance’s ability to claim that RT002 is superior to Botox. Being the same is tantamount to a failed study for RT002, because the whole point is to be superior to Botox.

Next, it is glaringly obvious that we have been given no baseline characteristics or demographics for the patient populations. This is of crucial importance in evaluating the data because of the different responses for older vs. younger patients and male vs. female patients.

By contrast, a read of Allergan’s Botox medical review shows that ALL of that information was included (as, of course, it should be).

The fact that the CMO quit his job just one day after this data fiasco should be seen as very telling.

It is also telling that (despite the supposedly compelling superiority of RT002 vs. Botox), Revance announced that it would no longer be comparing RT002 to Botox when it proceeds to Phase 3. This strongly reinforces the idea that RT002 does not really show any meaningful improvement over Botox.

The only question that remains is where should the stock trade once investors come to the conclusion that RT002 is not in fact superior to Botox. The easiest answer would be that the stock should trade back to $26.00, where it was prior to the Belmont presentation. But in fact if RT002 is not superior to Botox, the the real level for the stock should be dramatically lower.

Because Revance is not running a comparative study of RT002 vs. Botox in Phase 3, even if the product is approved, the company will have zero ability to market the product as being superior to Allergan’s Botox. This would place the company as another also-ran competitor among 4 other existing marketed competitors. This is a far cry from being the market dominating product.

In any event, from a simple common sense standpoint we can see from the Valeant sale of already approved and marketed Dysport for an estimated $700 million, that even in the best case scenario Revance is wildly overvalued at current prices.

Expect downside of 50% or more.

What’s Wrong With Tokai Pharma ?


Tokai’s attempt at a Phase 3 trial is based on data from just 6 patients out of 87 in Phase 2, based on after-the-fact cherry picking of data.

Tokai dramatically changed its trial design between Phase 2 and Phase 3 and the FDA has already warned Tokai about problems with its trial design.

Insider selling has been rampant ahead of preliminary data in 2016.

Tokai just filed a massive $150 million S3 registration statement in order to raise money before Phase 3 results are known.

Expect 60-70% near term downside in the stock.


Tokai Pharmaceuticals (NASDAQ:TKAI) is a one-product biotech company with a single drug in development. Galeterone is being developed for the treatment of prostate cancer for a very specific “subgroup of a subgroup” of patients for whom existing treatments are not effective. The sole reason for justifying taking Galeterone into Phase 3 trials was an after-the-fact “retrospective subset analysis” of its Phase 2 results, which saw encouraging results in just 6 patients out of 87. The structure of Tokai’s Phase 3 trial is such that failure is virtually guaranteed. As a result, Tokai has one of the highest short interest ratios of any stock on the NASDAQ. Insider selling has been rampant ahead of the pivotal trial results in 2016.

Because of its trial design, Tokai is virtually guaranteed to fail in Phase 3 and the stock will fall to cash value, a decline of at least 60%. Tokai recently filed a massive $150 million shelf registration statement in hopes of raising money before the Phase 3 results come public. The equity offering will add near term pressure to the stock price.

Background on shorting biotech stocks

The year 2014 could easily go down in history as “The Year of the Short Squeeze”. Many investors deliberately piled into controversial stocks for the sole reason that they were heavily shorted, banking on a short squeeze to give them an excess return. It was an unrestrained bull market and even sell side analysts began deliberately recommending stocks which were blatantly overvalued or even downright fraudulent on the basis that the high short interest might cause them to squeeze higher.

But now it is 2015 and heavily shorted stocks have been behaving more rationally. When the negative thesis becomes well understood, these heavily shorted stocks plunge as expected.

Shares of Wayfair (NYSE:W) were among the most heavily shorted of all stocks on the NYSE. Yet a brief report from Citron research sent the stock plunging by more than 40%.

Shares of AAC Holdings (NYSE:AAC) had a short ratio of nearly 40% of the free float. But a report from Bleecker Street Research sent that stock plunging by as much as 50%.

Shares of Amira Nature Foods (NYSE:ANFI) plunged by 40% following a report from Prescience Point, despite having a short ratio of around 40%.

More recently, heavily shorted Straight Path Communications (NYSEMKT:STRP) plunged by more than 40% following a report from Kerrisdale Capital. This was despite the fact that the stock was heavily shorted and had just 10 million shares outstanding.

The point from these examples is that a high short interest is now indicative of what it should be: namely that a company has significant problems and is likely to see sharp declines going forward. Unlike in 2014, investors who are short these problematic names have now demonstrated that they are in no rush to cover their short positions as they wait for the inevitable decline.

On the surface, shorting biotech stocks might appear to be downright stupid. If a drug wins approval, a short seller stands to potentially lose several hundred percent (or more). If things go right, the gains are typically limited to 70-80%. Before going short, investors must strongly assess the probability of the decline.

As a result, when a biotech stock has a massive short interest, it is a sign that the market has very strong reasons to be ultra confident that failure will be the outcome.

When I wrote “The Ugly Truth About Ohr Pharma” (NASDAQ:OHRP), the stock was still sitting at around $10. Yet I highlighted that fact that the company’s drug had already failed in past clinical trials and should be expected to fail again. It was a true no brainer and it attracted a huge short interest. When the drug failed (as expected), the stock cratered to around $2.00 – down by nearly 80%. Following that, I followed up with “Five Lessons from Ohr Pharma” to highlight where investors went wrong.

I made a similar case against Ziopharm’s (NASDAQ:ZIOP) Palifosfamide drug, which was also all but guaranteed to fail. This could easily be deduced by looking at the history and details of its clinical trials. When the stock was at $6.00, the short interest was massive with huge bets that the drug would fail. As expected, the drug failed and the share price crashed to $1.60 – down by nearly 70%. I followed up on that with “Why Retail Got Slaughtered on Ziopharm“. (Ziopharm has since been resurrected through its collaboration with Intrexon (NYSE:XON)).

More recently, shares of Xoma (NASDAQ:XOMA) plunged by 80% following the failure of its main drug. Yet a multi year analysis of its clinical trials showed that it too was all but guaranteed to fail. As usual, the huge short interest in the name should have alerted investors that something was very wrong.

The point is that in some cases, shorting biotech stocks can be a no brainer (and very high probability) win. By conducting a close analysis of clinical trial details, one can get a very clear idea where problems exist. A huge short interest in the stock is a sure sign that institutions have already done this work and are happy to take a lopsided bet against the stock, hoping for returns of at least 60% based on the fact that failure is almost inevitable.

Background on Tokai

Tokai Pharmaceuticals came public in September of 2014 when anything biotech was virtually guaranteed a hot reception. The stock came public at $15.00 and quickly rose to as high as $20.00. But since that time, the stock has floundered and now trades for around $11.00.

Seeking Alpha author Stock Doctor highlighted a bull case for Tokai in an article entitled “Tokai Pharmaceuticals: The Small Cap Biotech With The Billion Dollar Prostate Cancer Drug“. Upon publication, the stock immediately jumped by 20%.

However, since that time, the stock has declined to new lows and has become one of the most heavily shorted stocks on the Nasdaq. Insider selling has been rampant and Tokai has just filed to raise up to $150 million in an equity offering before Phase 3 results come out.

Clearly something is amiss.

The bull case for Galeterone

Galeterone is being targeted at a very specific subpopulation of prostate cancer patients who are treated specifically for “castration-resistant prostate cancer” or CRPC. Right now there are two drugs which compete for this market. Medivation (NASDAQ:MDVN) offers Xtandi, while Johnson and Johnson (NYSE:JNJ) offers Zytiga. Together, these two drugs bring in over $3 billion in annual revenues.

However, there is a problem with both drugs in that they fail to show results in a sub-subpopulation of CRPC patients with a certain truncated androgen receptor known as AR-V7.

As a result, Tokai is going after an even smaller population within this subpopulation.

In Phase 2 trials, Galeterone appeared to show effectiveness in AR-V7 patients, such that it could end up replacing Xtandi and Zytiga (but only in the subset of patients where those drugs do not work). This would create a market opportunity of perhaps $500 million to $1 billion.

That is the full extent of the bull case and it rests entirely on AR-V7.

The problems with Tokai and Galeterone

First off, it should be made clear the Tokai never even conducted a Phase 2 trial designed to test the effectiveness of Galeterone on AR-V7 patients. It also did not run a comparative trial designed to test effectiveness vs. Zytiga and Xtandi. Instead, the company merely ran a Phase 2 trial testing Galeterone for effectiveness in CRPC prostate cancer.

So how did Tokai come to focus specifically on AR-V7 patients ?

Tokai began Phase 2 trials for Galeterone in December 2012, with no mention of AR-V7. The study evaluated 87 patients who were specifically classified as CRPC. The data includes 17 patients who were non-metastatic and treatment naïve (no other drugs given) and 39 patients who were metastatic and treatment naïve. It also included 26 patients who had received Zytiga and 5 who had received Xtandi.

(click to enlarge)

Tokai was set to come public in September of 2014 with a drug that was undifferentiated from two existing blockbuster drugs. The company needed something to differentiate itself.

Fortunately there was already an article in the works in the New England Journal of Medicine highlighting the fact that both Zytiga and Xtandi had a weakness in that they were not effective in AR-V7 patients.

Ahead of its IPO, Tokai quickly began conducting after-the-fact data mining and found that there happened to be 6 patients out of these 87 patients who would be classified as AR-V7 and in whom Galeterone proved effective.

In scientific terms, this is called a “retrospective subset analysis”. In layman’s terms it is called data mining and “cherry picking”.

Tokai was no doubt well aware of the upcoming publication in the NEJM. Dr. Mario Eisenberger can be found as an author on the NEMJ study. He also happens to be a lead contributor on the Phase 2 trial for Tokai on Galetrone.

The following image shows the contributors to the NEJM article:

(click to enlarge)

The following image shows the contributors to the Galeterone study:

(click to enlarge)

As a result, by time Tokai filed to come public, the company had an IPO prospectus describing its strategy as one focused on the unique AR-V7 angle.

Tokai disclosed that:

In our ongoing Phase 2 clinical trial of galeterone, which we refer to as our ARMOR2 trial, we observed clinically meaningful PSA reductions in patients that were identified as having altered androgen receptors that were truncated in a retrospective subset analysis of seven such patients. Six of these patients showed clinically meaningful PSA reductions of at least 50%.

Structural problems with the Phase 3 trial

The following graphic shows the trial design for the Phase 3 trial for Galeterone.

(click to enlarge)

Because of the change in strategy, it is clear that Tokai is flying blind into its Phase 3 trial. The company plainly discloses that:

For drug and biological products, the FDA typically requires the successful completion of TWO adequate and well-controlled clinical trials to support marketing approval. In the case of galeterone, we intend to seek approval based upon the results of a SINGLE pivotal clinical trial. If the results of the trial are not robust, are subject to confounding factors, or are not adequately supported by other study endpoints, the FDA may refuse to approve galeterone based upon a single clinical trial.

But it gets worse.

Unlike the general Phase 2 trial which was evaluating Galeterone as a stand alone drug, Tokai has launched a Phase 3 trial which compares it specifically to Xtandi. The company also changed its endpoint to be radiographic progression free survival (“rPFS”).

As a result, the company truly has no idea what outcome to expect. It is as if the company never even conducted a Phase 2 trial at all !

From its disclosure:

Our ARMOR3-SV trial will be a randomized, open label clinical trial comparing galeterone to Xtandi in 148 metastatic CRPC treatment-naïve patients whose prostate tumors express the AR-V7 splice variant. The primary endpoint of the trial will be rPFS as determined by a blinded, independent central imaging assessment.

Once again, this is entirely different than its Phase 2 trial and gives the company no idea what to expect.

We have not conducted any clinical trials of galeterone for patients with AR-V7, comparing galeterone to a comparator drug or using a primary endpoint of rPFS. As a result, the results of the clinical trials that we have conducted may not be predictive of the outcome of our ARMOR3-SV trial.

Again it gets worse.

As for the rPFS endpoint, the company discloses that:

we are unaware of any completed or currently ongoing pivotal trials of treatments for prostate cancer for which the sole primary endpoint to support initial FDA drug approval was rPFS. As a result, we cannot be assured as to how the FDA will interpret any rPFS data that we generate in our ARMOR3-SV trial.

But we can see that the FDA has already warned the companyabout the use of this endpoint:

In August 2014, we met with the FDA to discuss plans for our ARMOR3-SV trial. At this meeting, the FDA advised us that, in its view, rPFS and the use of rPFS in the metastatic CRPC context is limited by difficulties in bone scan interpretation and the complexity of the criteria used to define progression, each of which creates uncertainty as to the ability of rPFS to predict improvements in morbidity or mortality.

The FDA specifically warned Tokai:

The FDA also advised us that if we used rPFS as the sole primary endpoint, this uncertainty would need to be overcome by a statistically persuasive large relative and absolute magnitude of improvement in rPFS as well as internal consistency across secondary endpoints, including a supportive result in overall survival.

The biggest and most fundamental problem here is that the Phase 3 trial designed by Tokai is virtually guaranteed to not meet these hurdles simply due to the size of the trial alone.

This can be seen by comparing the study size for the Galeterone trial to the trials of Xtandi and Zytiga.

(click to enlarge)

The problem with cherry picking data

Wikipedia describes Cherry Picking as follows:

The term is based on the perceived process of harvesting fruit, such as cherries. The picker would be expected to only select the ripest and healthiest fruits. An observer who only sees the selected fruit may thus wrongly conclude that most, or even all, of the fruit is in such good condition. A less common type of cherry picking is to gather only fruit that is easy to harvest, ignoring quality fruit higher up the tree. This can also give a false impression of the quality of the fruit (since it’s only a sample).

Cherry picking data can be very useful in attempting to make the case for a conclusion.

For example, within the NBA, China can point to 5 famous basketball players. They are Mengke Bateer, Sun Yue, Wang Zhizhi, Yao Ming and Yi Jianlian.

It would be very easy to produce a “retrospective subset analysis” of a small sample of NBA players which would could conclude that Chinese nationals are somehow uniquely suited to be basketball stars. The analysis could be designed to show this even though Chinese nationals are the exception rather than the rule in the NBA.

This is precisely what Tokai has done with its Phase 2 data.

Testing for AR-V7 – yet another problem

Perhaps the biggest elephant in the room is the fact that there is no easy way to even test for AR-V7 in practice. There currently exists no FDA approved test for AR-V7.

Tokai notes that:

We need to develop an analytically validated assay that sensitively detects AR-V7 in order to proceed with our planned pivotal Phase 3 clinical trial and develop and commercialize a companion diagnostic test for this assay in order to seek approval of, and commercialize, galeterone for patients with these types of truncated androgen receptors. We have entered into a collaboration with Qiagen to develop and commercialize the companion diagnostic. Clinical data obtained with the clinical trial assay in the Phase 3 trial will be used by Qiagen to support regulatory filings for the approval of the companion diagnostic for AR-V7 and by us to support our regulatory filings for approval of galeterone.

What it comes down to is that Tokai WILL be able to use a non-approved test for running finding patients for its clinical trials, but that commercial use of Galeterone CANNOT proceed until there is an FDA approved diagnostic test for AR-V7.

Insider selling and a massive S3 filing

Based on the information above, the rampant insider selling now becomes perfectly understandable.

Over the course of 2015, insiders have been selling millions in stock, all at prices below where the IPO was priced.

This includes the CEO, the CFO and the COO, as well as by partner Novartis. Needless to say, there have been no insider purchases in 2015.

(click to enlarge)

Adding to that pressure is the fact that Tokai just filed a massive $150 million S3 registration statement to raise money via an equity offering.

Tokai currently has $83 million in cash (about $4.00 per share). However, this cash will all be consumed by the Phase 3 trial. From the disclosure, we can see that the company “believes” it has enough cash on hand to fund the Phase 3 trial… but NOT enough to get to an NDA.

As a result, Tokai should be expected to launch an equity offering as soon as the S3 becomes effective, potentially in the coming days or weeks.


Tokai is a no brainer short that will likely return at least 60% on the downside. The incredibly high short interest is a reflection of the fact that the drug is virtually guaranteed to fail its Phase 3 trial and it has no other products in the pipeline.

Prior to its IPO, and based on its Phase 2 trials, Tokai Pharma did not have a drug that was differentiated from Xtandi or Zytiga. It did not have a drug that would be approved.

In response to findings from the New England Journal of Medicine, (and AFTER the Phase 2 had already begun) the company quickly changed its strategy to target AR-V7. The justification for this was simply a cherry picking exercise which noted effectiveness in just 6 patients out of 87.

The company dramatically changed the design of its Phase 3 trial to become a comparison between Galeterone and Xtandi. It also changed the trial design to use rPFS as its primary endpoint, despite warnings from the FDA about the shortcomings of this endpoint.

There has never been a drug approved using rPFS. Despite this, Tokai is attempting to do so with an inadequate sample size, and in a SINGLE trial rather than the TWO trials as required by the FDA.

As a result, the trial is all but guaranteed to fail. This is very similar to what we have seen with past biotech failures such as Ohr Pharma, Ziopharm and Xoma, among others.

Tokai should be expected to trade down to cash value per share.

However, the actual share price target on the downside is a moving target. Tokai will quickly consume all of its current cash balance in the Phase 3 trial. But the company is close to launching an equity offering to raise additional cash.

That soon-to-be launched equity offering will be the catalyst for the first leg down in the stock of perhaps 20-30%, leading to a total decline of at least 60-70% as we get closer to trial results in 2016.

The author was previously an investment banker for a major global investment bank and was engaged in investment banking transactions with a wide range of healthcare companies including medical device, pharmaceutical, genomics and biotech companies. The author has not been engaged in any investment banking transactions with US listed companies during the past 5 years. The author is not a registered financial advisor and does not purport to provide investment advice regarding decisions to buy, sell or hold any security. The author currently holds a short interest in TKAI and during the past 12 months has shared his fundamental and/or technical research with investors who hold a short position in the stock. The author may choose to transact in securities of one or more companies mentioned within this article within the next 72 hours. Before making any decision to buy, sell or hold any security mentioned in this article, investors should consult with their financial adviser. The author has relied upon publicly available information gathered from sources, which are believed to be reliable and has included links to various sources of information within this article. However, while the author believes these sources to be reliable, the author provides no guarantee either expressly or implied

BETR: A Busted IPO And A No Brainer Short


  • IPO’d at $18 with 100% of shares coming from insiders cashing out (company received no proceeds).
  • Stock fell immediately and has now fallen by 33%.
  • Company is saddled with debt and has no cash to conduct acquisitions.
  • IPO was rushed out due to rapidly falling growth rates and margins.
  • At least 30-40% further downside.

Company overview

Amplify Brands (NYSE:BETR) is the maker of Skinny Pop popcorn. Skinny Pop is not intended to be a weight loss item. The term “skinny” simply refers to the fact that it is simpler, using fewer ingredients. (This article provides a side by side comparison of Skinny Pop vs. key popcorn competitors).

Until April 2015, Skinny Pop was the company’s only product. In April the company acquired Paqui Tortillas and at that time changed its name to Amplify Brands. However, given that the acquisition price was a mere $12 million, it is still the case that Amplify “Brands” is still largely just a one product company – popcorn.

Amplify came public at a price of $18 in August valuing the popcorn company at over $1.5 billion in enterprise value. But the stock immediately traded down and now trades for around $12.00, down 33% from the IPO price.

Key statistics are as follows:

Market cap: $900 million

Cash: $17 million

Total debt: $198 million

LTM Rev: $151 million

(click to enlarge)


The IPO of Amplify Brands is proof positive that on Wall Street, anything is possible.

The typical justification for an IPO is that a growth company needs capital to expand. The IPO brings in that capital, often at a discount to fair value. The share price pops. The company uses the fresh capital to expand. The share price continues to rise based on stronger prospects. Voila. Everyone is happy. Capitalism works.

But with the IPO of Amplify Brands , we can see that sometimes a sneaker can slip through the cracks and the IPO market can just act as a dumping ground for private equity firms who need to unload one of their portfolio companies as quickly as possible.

TA Associates purchased a 74% stake in Skinny Pop in August of 2014 for just $320 million. Within 8 months (April 2015), the company had already hired Goldman Sachs to sell the stake to a bidder. However, when no bidder materialized, TA needed an alternative.

Skinny Pop has taken on nearly $200 million in debt and ended up paying dividends to shareholders (ie. including TA Associates) of $80 million. In April, just as TA was attempting to sell the company, Skinny Pop then acquired a tiny tortilla chip maker for $12 million and changed its name to “Amplify Brands”. Now, as a seemingly diversified snack maker, the company filed for an IPO with Goldman as the underwriter.

The most unusual feature of this offering was that in the IPO, fully 100% of the shares being offered to the public came from selling shareholders. This means that none of the proceeds raised are going to the company. In fact, 82% of the shares came straight from TA.

Clearly this should be a tough sell. After all, if the insiders are all looking to cash out and the company doesn’t derive any benefit from the IPO, then why should anyone buy it ?

There are a few key elements required in order to make such a transaction happen. Especially when dealing with lofty multiples such as Amplify.

First requirement: the appearance of growth prospects

First off, there needs to be the appearance that there are still substantial growth prospects ahead for the company. It is plain to see that Skinny Pop has already experienced a surge in growth. In past years the company was experiencing triple digit growth as it expanded from a presence of just a few thousand stores to its current level of nearly 50,000 stores. But by now, Skinny Pop has already penetrated the largest grocers and convenience stores in the country. This includes Sams Club, Costco, 7 Eleven, Wal Mart, Kroger, CVS and Target.

It is therefore not surprising that growth has declined dramatically, as shown below:

(click to enlarge)

Meanwhile, operating margins have also been cut in half.

(click to enlarge)

These slowing growth rates and falling margins would normally create a major problem for the IPO.

At an IPO price of $18, Skinny Pop would be coming public with an enterprise value of over $1.5 billion. That is more than 50% larger than the size of the entire addressable market for ready-to-eat popcorn in the US (according to Amplify’s own IPO prospectus). It is also a valuation of more than 10x 2014 revenues ! So there needed to be something else to the story.

As a result, in April 2015 (just when TA was trying to find a buyer for Skinny Pop) the company acquired Paqui Tortillas. The acquisition price was just $12 million, but it served a much greater purpose.

Skinny Pop could now be marketed to investors as a diversified snack company and the size of the popcorn market would not be a limiting factor. As a result of this tiny acquisition, Skinny Pop changed its name to “Amplify Brands” just shortly before the IPO.

Second requirement: selecting the right underwriter

IPO’s are supposedly priced for to provide initial buyers with a pop in share price. That is the way IPOs are supposed to work. But with Amplify, we can see that the stock traded straight down from the very beginning and has continued to trade off by more than 30%.

Investors were clearly not buying the “diversified snack company” line. Nor were they buying the hyper growth story.

The question then becomes: “if this IPO was so bad, how did it get completed in the first place”.

The fact is that Goldman Sachs brings many very attractive IPO deals to market. If you play 10 of these deals, you will probably end up making decent money in seven of them. And in perhaps three of them you will hit some serious home runs. It is worth losing some money on the occasional bad deal in order to maintain a relationship for future home runs.

As a result, when Goldman launches a “favor deal” like this one, there are no shortage of investors who will buy a small slug as a favor to Goldman. They then hold for a brief period and start quietly unloading while they can. This is exactly why the deal never traded up and exactly why the stock is now down by 30%.


The bull case on Amplify rests on the assumption that Skinny Pop will be so popular that it will literally take over the salty snack market and will be the number one Ready-to-Eat popcorn maker.

But we can already see that there are dozens of competitors out there with a product that is nearly identical. These products are sold in the same retail outlets and at similar prices as Skinny Pop.

A list of these competitors can be found on the GoodGuide and it runs 15 pages long with 197 products !

(click to enlarge)

Evaluating Amplify at a price of $12

TA Associates paid $320 million for their 74% stake, valuing the company at $430 million.  That equates to a price of around $5.73 per share for TA.

But it is clear that even at $5.73, TA overpaid substantially. We can see from the above charts that TA acquired Skinny Pop when growth was still clocking in at 160%. Operating margins had just declined from 47% to 20% for the first time.

Now we can see that sales growth has plunged to just 33% from 160%, while operating margins have failed to recover.

At a price of $12.00, Amplify has an enterprise value of around $1.1 billion. That equates to a whopping 7.3x LTM sales. Amplify is clearly being priced for hyper growth.

To put this in perspective, when TA acquired its stake in the company one year ago, it did so at a multiple of just 4.5x sales. Since that time, the company has taken on additional debt while growth has slowed and margins have fallen.

Despite the lofty multiple for Amplify, growth is now expected to fall even further.

On August 31st, the managers and co-managers on the IPO all initiated coverage on the stock. Not surprisingly, 4 out of 5 of them initiated with a price target of exactly $18 (the same as the IPO price).

But it is interesting to note that co-bookrunner Credit Suisse initiated with a target price of just $13.00. The key reason for the low price target is that Credit Suisse feels that the only way to justify a higher valuation is the attribute value to acquisitions that have not yet happened. Credit Suisse also assumes that the rate of growth on sales will be slowing to just 20% by 2018.

Cash, debt and future acquisitions

Because Amplify did not receive any proceeds in the IPO, we are now looking at a $900 million market cap company which has just $13 million in cash against nearly $200 million in debt.

Again for perspective, Amplify has $10 million in debt coming due within 12 months and an additional $14 million in consideration due to founders within 12 months, totaling $24 million against its $13 million in cash.

Credit Suisse has estimated that EBITDA for 2015 will come in at $72.2 million. That puts Amplify at an EV/EBITDA of more than 15x. This means that Amplify is going to face limitations on how much it can further borrow.

What all of this means is that Amplify is saddled with debt and has limited cash with which to conduct acquisitions to achieve required growth.


TA Associates still owns 58% of Amplify. And we have already seen that TA has been in a rush to sell its stake as quickly as possible. It was only 8 months after the stake was acquired that TA began shopping it via Goldman Sachs.

TA paid just $5.73 per share for its stake in Amplify. But that is now largely irrelevant. With the proceeds from the IPO along with its share of $80 million in special dividends, TA has already received back 100% of its original investment in Amplify. Anything sold from here on out is pure profit for TA.

As a result, TA’s 58% stake in Amplify creates a massive overhang on the stock.

More importantly, we can see from the post IPO trading that the initial IPO buyers have been slowly bleeding out stock. This was clearly a favor deal for Goldman Sachs, such that buyers are simply looking to get out of their positions and (hopefully !) lose as little money as possible.

This steady stream of sellers also creates significant downward pressure on the stock.

When TA acquired its stake at $5.73, Skinny Pop was still posting growth at around 160% y-o-y. That is largely what justified the premium multiple for the company at the time. But now growth has plunged to just 30%. This is why TA was in such a rush to sell the company after just 8 months. (A normal PE holding period would be around 3-7 years.)

As a result, it is tough to say where Amplify will ultimately settle down. But with the abundance of sellers and little chance of meeting growth estimates, we should see at least 30-40% downside from current prices.

Additional disclosure: The author was previously an investment banker for a major global investment bank and was engaged in investment banking transactions with a wide range of consumer companies. The author has not been engaged in any investment banking transactions with US listed companies during the past 5 years. The author is not a registered financial advisor and does not purport to provide investment advice regarding decisions to buy, sell or hold any security. The author currently holds a short interest in BETR and during the past 12 months has shared his fundamental and/or technical research with investors who hold a short position in the stock. The author may choose to transact in securities of one or more companies mentioned within this article within the next 72 hours. Before making any decision to buy, sell or hold any security mentioned in this article, investors should consult with their financial adviser. The author has relied upon publicly available information gathered from sources, which are believed to be reliable and has included links to various sources of information within this article. However, while the author believes these sources to be reliable, the author provides no guarantee either expressly or implied

OMER: Watch for a 50% drop in Omeros


  • Omeros recently spiked on release of new Phase II drug data for OMS-721.
  • The stock quickly gave up almost all of these gains once the details of this trial were better understood.
  • Omeros had previously been hitting a new 52 week low of $11.93 due to the failed launch of its only commercial product, Omidria. But shares appeared to be headed lower.
  • Omidria continues to fail and the share price should retrace to well below $11.00. Ultimately the stock should settle around $6-8.
  • Omeros desperately needs to raise money in the near term via an equity offering any day now. This is the near term catalyst for a sharp decline.

Company Overview

Name: Omeros Corp (NASDAQ:OMER)

Market Cap: $734 million (fully diluted)

(includes 9.5 million shares from options and warrants)

Share price: $15.xx

Avg. Volume: 2 million shares

LTM Revenues : $3 million

Cash: $51 million (as of June 30)

Total debt: $30 million

Cash burn: $34 million / 6 months

Background – failed drug launches

Shorting stocks into a failed drug launch is about the closest thing there is to printing free money. Sell side analysts routinely put unrealistic sales estimates on new drugs even when there are obvious signs that the market will not accept the drug commercially. The sell side targets result in vastly overpriced stocks which inevitably correct as the poor launch results become visible over time. When companies are forced to raise cash on the back of a failed drug launch, the correction is even further accelerated.

Back in May I highlighted a short opportunity with Keryx Biopharm (NASDAQ:KERX). Keryx was trading at around $10 with a market cap of around $1 billion, despite generating sales for its only drug of less than $1 million. Even these paltry sales were only achievable when Keryx used overly aggressive marketing tactics, conveying an iron benefit for which its Auryxia drug was not approved. The sell side had told us to expect sales of over $20 million for the year, but by May it was clear that this was pure fantasy. Even with the stock trading at a 52 week low of around $10, the stock was a compelling short. Keryx now trades for around $6, down by nearly 40% in just 3 months. Previously the stock had traded at over $18 due to pre-launch hype for Auryxia thanks to sell side analysts.

(click to enlarge)

Another example is the failed launch of Afrezza by Mannkind (NASDAQ:MNKD). Mannkind is backed by billionaire Alfred Mann, which generated ample enthusiasm for the prospects of this inhaled insulin drug. Even as the failure of the launch became evident, the stock still traded as high as $7.00 as recently as June. The stock now trades for just $3.50, down 50% in 3 months.

As with Keryx and MannKind, we are about to see a similar phenomenon with Omeros Corp. But with Omeros, the situation is exacerbated by the company’s need to raise cash in the near term.

Shares of Omeros now represent a compelling short opportunity for a variety of reasons. There is also a catalyst for a near term decline. The first issue is that the launch of its only commercial product has been an abject failure. Further revenues will not materialize in any amount remotely near what the sell side had told us to expect. The notion of getting to $100 million is pure nonsense.

The shares recently spiked due to the release of Phase II data on a separate drug, but now they are quickly giving up all of these gains as investors understand the tiny scope of this preliminary trial and the lack of trial design.

However, the shares currently remain elevated vs. where they were prior to this data release, creating the compelling short opportunity. Much of the reason that Omeros currently trades above $6-8 is that the market believes that Omeros has an additional broad pipeline of potential drugs. It is the “multiple shots on goal” theory.

But this is mistaken. Three of these drugs have either been discontinued or are on clinical hold by the FDA. There is no value to them. The only Phase III candidate has already been licensed out and offloaded for a minimal sum. Again, there is no further value there either. And with OMS-721, we can see that the stock is already giving up all of its gains due to the weak trial design and small trial size.

Prior to the release of the recent Phase II data, Omeros was hitting new lows of $11.93. Were not for the data driven spike, the stock appeared to have been headed steadily lower. Omeros does not currently have enough cash to even fund its trials and must raise capital in the very near term. As a result, the company needs to issue stock, which will ultimately see the stock trading at around $6-8.


Omeros Corp has a fully diluted market cap of $734 million despite the fact that it has only a single commercial product (Omidria) which is now suffering through a failed launch. Omidria is basically just an NSAID (Non Steroidal Anti-Inflammatory Drug) which controls pain and inflammation during cataract or lens surgeries. It also controls pupil dilation.

As of Q2, the company had just $51 million in cash vs. a 6 month cash burn of $34 million. By now we can estimate that cash is down to $30-40 million. Yet cash burn now needs to accelerate due to ongoing clinical trials. As a result, the company simply must issue equity in the near term.

Based on the failed drug launch and the stock offering catalyst, we can expect the stock to fall by 40-50% from current levels.

The failure of Omidria to achieve meaningful sales should have come as no surprise to investors. The product is simply a combination of two existing generic drugs which can be easily compounded by any compounding pharmacy for about 1/10th the cost of what Omeros is attempting to charge.

Despite this obvious competitive problem, the sell side had very aggressive sales estimates following the company’s Omidria launch earlier this year. This is identical to what we saw with Keryx and MannKind.

The sell side estimated that Omidria sales for 2015 would come in at over $20 million, while sales in 2016 would exceed $100 million. Omidria was launched earlier this year with sales so far of around just $3 million. However, according the recent 10Q these sales include at least 1 month’s worth of inventory stocking by wholesalers as opposed to end demand to be used in procedures. As a result, true sales should be estimated as in the range of $1-2 million so far.

Omeros has no other viable pipeline

Management has continued to tout its pipeline outside of Omidria. This has helped to supprt the stock at prices over $10 for some time. However, the fact is that what they are touting does not really exist.

Looking at its investor presentation, Omeros does seem to have a lot of other drugs in the pipeline. However much of this can be seen as very misleading. The chart below shows Omeros’ pipeline as per its presentation to investors. The red lines and text were added by me to illustrate where this pipeline is bogus.

(click to enlarge)

The bulk of the programs that are listed by Omeros are simply preclinical . There have been no trials initiated and there should only be minimal (if any) value attributed to them. Some of these programs have been ongoing for as long as 7 years without even making it into clinical trials. Yet management still continues to tout them as part of its “pipeline”.

But here is the real problem. There is only one Phase III candidate listed in Omeros’ pipeline. This is for OMS-103 to be used for arthroscopy indications. That drug already failed to reach statistical significance in its primary endpoint in clinical trials. In June of 2015, Omeros basically offloaded the drug to Faragon NV for up to $10 million in milestone payments should they ever occur. It is basically worthless.

Within the several Phase II programs, we can see from the recent 10K(but not in the presentation to investors) that thee of these programs have either been cancelled or placed on clinical hold.

OMS-824 for CNS disorders (two listings below) was placed on clinical hold by the FDA in October of 2014.

OMS-201 for urology uses in no longer in active clinical trials. These three items are for all intents and purposes dead. There is no value to them.

OMS-405 is for opioid and nicotine addiction. However this is still in the recruiting stage for a Phase II trial and should not provide any value or catalyst for the stock in the near future.

That leaves us with OMS-721 which was what caused the stock to spike when the data was recently released. So let’s take a look at why the gains didn’t hold following the release of data.

Looking at the data for OMS-721

On August 14th, Omeros was hitting new lows of $11.93. The next day, Omeros released data on the mid-dose cohort for its OMS-721 and the stock quickly spiked to as high as $30.00. But now the stock has given up nearly all of those gains, trading at just $15.00. What happened ?

OMS-721 is being studied for the treatment of thrombotic microangiopathies (TMAs). TMAs are a family of rare, debilitating and life-threatening disorders characterized by excessive thrombi (clots) – aggregations of platelets – in the microcirculation of the body’s organs, most commonly the kidney and brain.

The data was indeed positive and the fact that Omeros has obtained Orphan Drug Status for OMS-721 is what led the stock to spike so high. Clearly, some might have thought, this could represent another distinct revenue stream for Omeros and the Orphan status could make that meaningful.

Or perhaps not.

The reason why the stock is now plunging is that the market has become aware that the trial applied to just 5 patients and there was not even a placebo arm. More importantly, it does not appear that the drug would be competitive with the existing drug Soliris by Alexion.

From the data release,

In the mid-dose cohort, the two patients with plasma therapy-resistant aHUS demonstrated:

• 47% increase in mean platelet count, resulting in both patients having counts in the normal range

• 86% decrease in mean schistocyte count, with schistocytes disappearing in one patient

• 71% increase in mean haptoglobin with both patients reaching the normal range during treatment, one slipping slightly below normal at one week following the last dose

• 5% decrease in the mean levels of LDH, with levels in both patients remaining slightly elevated above normal range

The key concern from the above data is the fact that there was only a 5% decrease in the mean levels of LDH, with levels remaining elevated. Soliris has shown normalization of LDH levels in up to 80% of patients.

It was also noted that with the mid-dose patient with TTP, “Laboratory parameters did not show consistent improvement”. That was for one out of the five patients.

The first conclusion is that all in all there should have been nothing to get too excited about with the release of data from OMS-721. There should have been very little movement in the stock in the first place. This is why the stock is now giving up all of its gains.

KEY POINT: But the key takeaway here is that over the course of 7 years, and after spending nearly $300 million, Omeros has produced just a single approved drug…which happens to be nothing more than the combination of two existing generic drugs.

Looking at the failed launch of Omidria

Looking at the overall pipeline for Omeros, including the new data from OMS-721, it is clear that the overwhelming majority of the value of the company should be based simply on Omidria. Omidria is Omeros’ only FDA approved product and the only one which has been commercially launched.

Sell side analysts have put forth projections for Omidria sales which are as high as $100 million in 2016. This is what kept the share price elevated prior to launch at levels of $20-25.

Once we were able to get past the initial launch and see how sales actually materialized, the share price was quickly cut in half. Just a few weeks ago (prior to the recent spike) the stock was hitting new lows daily, as low as $11.93.

Omidria is simply a combination of phenylephrine and ketorolac which is injected into the eye during cataract surgery or intraocular lens replacement. The combo treatment helps to maintain pupil size while reducing pain and inflammation.

The key thing to realize here is that both phenylephrine and ketorolac are existing generic drugs. Omidria is simply a formulation which combines the two and which was subsequently FDA approved.

Omidria did obtain Medicare pass through status for reimbursement at around $400 per vial. However this is about 10x what it would cost a compounding pharmacy to simply mix the two medications on its own. Most ophthalmologists have ample access to compounding pharmacies.

As a result, the only real reason to use Omidria is that it is more convenient and saves the step of having the compounding pharmacy mix the drug. It is clear from the results post launch that this has not been enough of an incentive to generate meaningful revenues. It is also clear from the failed launch that this combination of two readily available generics will never be a $100 million drug. Not by a long shot. At best, we will continue to see a few million in sales from Omidria.

Similar to what we saw during the failed launches for Keryx and MannKind, the share price for Omeros is steadily grinding lower, rather than suddenly plunging. But unlike Keryx and MannKind, Omeros is in urgent need of raising money. With a minimal viable pipeline, there is very little to incentivize investors, such that the impact on the stock will be larger than usual.

The catalyst for a share price drop will be a near term equity offering at a meaningful discount. Such an offering could be expected to happen any day now.


Over the past 7 years, Omeros has spent nearly $300 million on a variety of endeavors and the only thing it has to show for it is a single approved drug, Omidria, which happens to be nothing more than a combination of two existing generic drugs.

Aside from its already-launched Omidria, Omeros does not have a viable pipeline. The bulk of its programs are simply preclinical and not even in FDA trials. Of the ones which have reached clinical stage, 3 have either been placed on clinical hold or have been discontinued. One has already been offloaded to another company for a mere $10 million of potential milestones should they ever occur. That leaves us with OMS-721, where the recently announced trial had just 5 patients and no placebo arm with fairly mediocre results. There should be little if any value attributed to OMS-721 until there is a larger Phase III trial in 2016 or 2017.

That leaves Omeros with a just single commercial product, Omidria. Omidria is FDA approved and has already been launched. But because it is simply the combination of two readily available generics, it has not generated meaningful sales post launch.

Omeros had just $51 million in cash as of June. Yet the company burned $34 million in the 6 months ended June. By now they are likely down to $30-40 million in cash. Unusual for a biotech, the company has $30 million in debt.

Against this, the company must fund a 40 person sales force as well as its ongoing clinical trials for OMS-721. It is quite clear that the company doesn’t have the cash to do this without raising equity financing in the very near term, which will add significant pressure to the share price.

With the share price spike now fading quickly, I expect that the company will issue shares very soon and that the share price will quickly head back to $11 or below. Given the failed status of Omidria, the share price will likely find a floor at around $6-8.

This is based on the assumption that Omeros raises $80 million at $12, issuing 6.7 million new shares, bringing fully diluted share count to 54.07 million. It also assumes that sales for 2015 and 2016 stabilize in the range of $10-15 million, rather than $20-100 million as per sell side estimates.

Note that Omeros excludes from its share count the 9.5 million options and warrants. (See page 8 of the recent 10Q).









The author was previously an investment banker for a major global investment bank and was engaged in investment banking transactions with a wide range of healthcare companies including medical device, pharmaceutical, genomics and biotech companies. The author has not been engaged in any investment banking transactions with US listed companies during the past 5 years. The author is not a registered financial advisor and does not purport to provide investment advice regarding decisions to buy, sell or hold any security. The author currently holds a short interest in OMER and during the past 12 months has shared his fundamental and/or technical research with investors who hold a short position in the stock. The author may choose to transact in securities of one or more companies mentioned within this article within the next 72 hours. Before making any decision to buy, sell or hold any security mentioned in this article, investors should consult with their financial adviser. The author has relied upon publicly available information gathered from sources, which are believed to be reliable and has included links to various sources of information within this article. However, while the author believes these sources to be reliable, the author provides no guarantee either expressly or implied

SXC: SunCoke Confides To IRS: “We Don’t Qualify For MLP Status”

Yesterday I wrote an article highlighting the risk that GP SunCoke Energy (NYSE:SXC) and its LP SunCoke Energy Partners LP (NYSE:SXCP) would lose their MLP qualification due to new proposed regulations from the IRS which explicitly excluded the coking of coal from being treated as qualified income.

Investors were rightly concerned and the stock quickly hit a new 52 week low of $12.82. However, without the benefits of the MLP structure, SunCoke should clearly head much lower than that.

SunCoke responded with a press release which stated that the company had, on the same day, submitted a joint comment letter to the IRS seeking clarification. The stock jumped sharply,for a time, but then gave up its gains to close flat on the day.

SunCoke stated categorically that

Although we are seeking clarification of the proposed regulations, we believe that the proposed regulations as currently drafted support the position that the coking of coal is a qualifying activity.

There are two not-so-funny things to note here.

The first is that the new proposed regulations have been public for almost 6 weeks now and SunCoke only felt the need to correspond with the IRS following an article from a random blogger (me) who highlighted these problems to the public. Despite its assurances to the contrary, it seems that SunCoke itself was unaware of these implications until just the time I pointed them out.

The second (and much more serious) thing to note is that SunCoke has now explicitly told investors the exact opposite of what it has stated to the IRS in writing. (pdf download available here)

Again, SunCoke told investors that “we believe that the proposed regulations as currently drafted support the position that the coking of coal is a qualifying activity”.

This is very important because it had a material impact on the stock. SunCoke traded as high as $14.78 – more than 15% above the day’s low of $12.82.

But in their letter to the IRS, SunCoke explicitly stated (on page two, paragraph three) that:

As a result, under the Proposed Regulations as currently drafted, the listed “mining processes” generate qualifying income and the “refining” of ores generates qualifying income but the processes that in fact occur between “mining” and “refining” do not. Thus, the Proposed Regulations would exclude from qualifying activities numerous mineral processing activities, including the coking of coal

SunCoke Letter to IRS

Note: the above document is 9 pages long. I have highlighted the relevant sections in green on pages 2, 7 and 8.

The entire tone of the letter to the IRS is far different than the confidant tone that was shown to investors in the press release. Not only does SunCoke admit that under the proposed regulations it doesn’t qualify as an MLP, but throughout the letter, SunCoke is visibly pleading with the IRS to not take the course that it has, stating in different instances:

“This result could not have been intended….”

“Fortunately, it is an error….”

“One can only conclude that Congress intended….”

“It is difficult to understand why…”

Problem #2: A “substantial” problem

My original understanding of the argument being raised by SunCoke was that they believed they still qualified to be treated as an MLP because the chemical changes involved in coking were not “substantial”. In other words, SunCoke acknowledges that there are chemical changes, but supposedly not to such an extent that it would disqualify SunCoke’s MLP structure.

Yet for some reason SunCoke is now fighting to get the IRS to include activities which DO CAUSE substantial chemical change.

From page seven, we can see that SunCoke states:

There is simply no basis in section 7704 or in the legislative history for imposing a blanket exclusion of any activity that results in a “substantial” physical or chemical change from the definition of processing or refining.

So why is SunCoke fighting this particular fight ?

I think I made a clear case in my last article that coking involves a “substantial” chemical change. The fact that SunCoke is now fighting to have such “substantial” activities included in the new regs seems to bolster the argument even more.

Problem #3: MACRS (I missed this one myself….)

In addition to the requirement of engaging in a qualified activity, the new Proposed Regulations have an accounting requirement which SunCoke does not appear to meet. It is regarding the Modified Accelerated Cost Recovery System (MACRS) for depreciation.

Once again, SunCoke has explicitly told the IRS that “we don’t qualify”.

SunCoke states (page eight):

For example, SunCoke classifies its coke production assets under class 33.4, which includes “assets used in coke production.” That category, however, also encompasses assets used in a broad array of processes generally relating to the steel industry…some of those activities, such as the refining of iron ore, clearly are qualifying activities…but other activities, equally clearly, would not be qualifying activities. Accordingly, the MACRS limitation should be deleted from the final regulations.

Problem #4: There will be no grandfathering

In the press release, SunCoke says that:

In order to be grandfathered, a partnership either must have received a private letter ruling or be engaged in the activity based on a reasonable interpretation of the statute and its legislative history. We believe that the receipt of the opinion of our counsel, Vinson & Elkins LLP, that our coking operations generate qualifying income provides that reasonable interpretation.

We believe that section 7704(d)(1)(NYSE:E) and its legislative history fully support the position that coking of coal generates qualifying income and that any final regulations will clarify the coking of coal is a qualifying activity.

So SunCoke’s only basis for stating this opinion is that their law firm had told them so. This is the same law firm that apparently missed the impact of these changes for the past 6 weeks.

And with respect to that same section 7704(d)(1) referenced above, on page two (as we saw before) of the letter to the IRS SunCoke states that:

Inexplicably, the Proposed Regulations define the independent section 7704(d)(1) activity of “processing” to include on the “mining processes” described in Treas Reg. §1.613-4(f)(1)(ii)…By doing this, the Proposed Regulations ignore the well-established and long-standing definition of “mining”…and effectively eliminate the word “processing” of ores and mineral from the statute…. Thus, the Proposed Regulations wouldexclude from qualifying activities numerous mineral processing activities, including coking of coal”

Thus, SunCoke has no real basis for saying that they “believe” that they will be grandfathered.


As evidenced by the concerns raised in SunCoke’s letter to the IRS, SunCoke has a real problem. SunCoke does not qualify as an MLP.

Yet these problems have been in existence for 6 weeks. And only after my article did SunCoke address them with the IRS. One can now better understand the frustrations expressed by Jet Capital in its 13D’s. Management clearly comes across as a group of uninformed bumblers.

More importantly, I think I have never seen a situation where a company has filed an explicit press release to assure investors while, on the same exact day, directly contradicting those exact assurances in a letter signed by the CFO. This appears to be even worse than just bumbling.

The IRS letter from SunCoke spells out with crystal clarity why SunCoke does not qualify as an MLP and why it will not be grandfathered. As a result, there is still a very clear 30-40% near term downside in the stock.

Now that SunCoke is actually aware of the problem, we can expect the company to strenuously object to the Proposed Regulations in letters to the IRS, citing errors and conflicts with the intentions of Congress, and etc. This is exactly what Westlake Chemical and several other affected paper companies will be doing with their own (different) problems until the comment period ends in August. But as it stands, SunCoke simply does not qualify as an MLP. So the best they can do is hope that the IRS will change its regulations in these specific areas to benefit a single corporate interest, namely SunCoke.

As is generally the case, the smart money has already started to figure this out while the laggards are still scratching their heads. Following the assuring press release from SunCoke, the stock rose as high as $14.72 – up by 5% on the day. But it quickly gave up all of those gains to close flat on the day. I therefore believe that I am not the only one to have read this letter to the IRS. As the letter gets more broadly read, SunCoke should see immediate downside.

Additional disclosure: The author was previously an investment banker for a major global investment bank and was engaged in investment banking transactions with a wide range of industrial companies. The author has not been engaged in any investment banking transactions with US listed companies during the past 5 years. The author is not a registered financial advisor and does not purport to provide investment advice regarding decisions to buy, sell or hold any security. The author currently holds a short interest in SXC and during the past 12 months has provided fundamental and/or technical research to investors who hold a short position in the stock. The author may choose to transact in securities of one or more companies mentioned within this article within the next 72 hours. Before making any decision to buy, sell or hold any security mentioned in this article, investors should consult with their financial adviser. The author has relied upon publicly available information gathered from sources, which are believed to be reliable and has included links to various sources of information within this article. However, while the author believes these sources to be reliable, the author provides no guarantee either expressly or implied.

SXC: New IRS Rules Could Eliminate SunCoke’s MLP Status

  • A new proposed ruling by the IRS looks set to disqualify SunCoke’s income for MLP purposes.
  • This very subtle change is just now being spotted by more savvy investors who are already dumping the stock while they can.
  • Without the MLP benefits, SunCoke could fall by 30-40% more.
  • A similar change caused a rapid 30% drop in Westlake Chemical Partners in May.


A proposed ruling from the IRS disqualifies for MLP purposes income which is derived from activities which cause “substantial chemical change” in processing or refining. The IRS specifically noted that the new rules are consistent with definitions found within the existing Code.

What the market has missed is that “chemical change” is a defined term with the IRS. Within the existing Code (§1.613-4), the IRS specifically DEFINES “chemical change” by giving the example of “the coking of coal”. As a result, it looks as if SunCoke is set to lose its MLP status based on the proposed regulations. SunCoke has already begun a noticeable selloff. But without MLP status it could easily fall by an additional 30-40%.

Author’s Note: prior to publication, the author did speak with management at SunCoke. Management felt that because chemicals were not being added in the production of coke that the “chemical change” involved in production was not “substantial”. Management is taking the stance that coking is simply refining and the removal of impurities. Management confirmed that they did not receive a Private Letter Ruling from the IRS for coking, but instead had received only an opinion from their law firm. But even this opinion was only received prior to the new IRS changes. As with Westlake Chemical (NYSE:WLK), SunCoke management is in the process of submitting comments to the IRS.

Section I: Background

On May 6th, 2015, the IRS released new proposed regulations which substantially change the rules relating to qualifying income for MLPs from the processing, refining and transportation of minerals or natural resources which allows a business to be treated as a partnership for U.S. federal tax purposes.

The full text of the proposed changes was later posted as a bulletin to the IRS website on May 26th and can be found here.

The proposed changes had an immediate impact on the Westlake Chemical Partners LP (NYSE:WLKP). Within 3 days, the shares had fallen by as much as 30%. This was the case even though West Lake had previously obtained a Private Letter Ruling (“PLR”) to the effect that the production, transportation, storage and marketing of ethylene and its co-products constitutes “qualifying income” within the meaning of the Code.

(click to enlarge)

According to the new proposed regulations, because Westlake had previously obtained the PLR, its existing activities would continue to be treated as qualifying income for 10 years. And yet the shares still fell by as much as 30% before stabilizing. The shares did subsequently bounce slightly once investors grasped the 10 year grandfather period.

Section II: Changes affecting SunCoke Energy

The situation is much worse for SunCoke Energy Inc (NYSE:SXC) and its LP SunCoke Energy Partners LP (NYSE:SXCP). A few of the more savvy investors must have already spotted this, explaining the recent selloff in SunCoke.

Shares could easily fall by 30-40% once the implications of the new regulations are fully grasped by investors as a whole.

SunCoke is engaged in the processing of coal into coke for steel making. What the larger market has entirely missed is that the new regulations look to outright prohibit coking activities from being treated as qualifying income.

In addition, because SunCoke had not received a PLR from the IRS for coke production, it would not get the 10 year extension for existing activities, as did Westlake. I did confirm with management that they did not receive a PLR from the IRS.

A good overview of the general rule changes is summarized by Chadbourne and Park:

The proposed regulations treat income as qualifying income only ifit is from engaging directly in “exploration, development, mining or production, processing or refining, transportation or marketing” of minerals or natural resources or from providing a limited class of services to companies that are directly engaged in such activities.

A more detailed read of the proposed rule making reveals the problem which is unique to SunCoke.

We can see clearly from item 1.D of the new proposed rule making that the IRS states specifically that:

processing or refining does not include activities that cause a substantial physical or chemical change in a mineral or natural resource, or that transform the extracted mineral or natural resource into new or different mineral products, including manufactured products. The Treasury Department and the IRS believe that this rule is consistent with definitions found elsewhere in the Code and regulations. See, for example, § 1.613-4(NYSE:G)(5).

(See appendix I for full text of Item D)

Although it is more difficult to find, we can also see from the US Federal Tax Code (§ 1.613-4) that the term “chemical change” is well defined. In fact, the tax code actually uses coking as a specific example to outright DEFINE an activity that constitutes “effecting a chemical change”.

This is what the overall market has missed. IRS Code § 1.613-4states very clearly and specifically that:

The term treatment effecting a chemical change refers to processes which transform or modify the chemical composition of a crude mineral, as, for example, the coking of coal.

(See Appendix II for full text of this definition section)

KEY POINT: The recent proposed rule change made it clear that “this rule is consistent with definitions found elsewhere in the Code”. And we can see from the definitions provided by the IRS that there is just a single example to define “chemical change”. That single example is “the coking of coal”.

Section III: The chemical change in coking

Any variety of sources can be used to see the exact chemical change involved in coking. For example, Britannica.com includes the following diagram.

Additional sources can clarify the above reaction diagram as:

When heated to high temperatures, in the absence of air, the complex organic molecules break down to yield gases, together with liquid and solid organic compounds of lower molecular weight and a relatively non-volatile carbonaceous residue ( coke ). Coke, then, is the residue from the destructive distillation of coal.

Some of this should be viewed as common sense. The diagram above shows the before and after of coke vs. coal. Some of the byproducts such as the gases and the ammonia (released during the chemical change) can even be sold off separately. Coke is a different compound than the original coal. Due to the chemical changes, coke is also much lighter than coal, which is a physical change.

Section IV: Impact on SunCoke

With SunCoke, the most compelling short opportunity is with the GP. Although the LP should be expected to fall substantially as well.

At current prices, the driving value proposition in SunCoke Energy (the GP) is the prospect for increased dropdowns going forward. This has been clearly stated in a series of 13D’s by Jet Capital and was amplified recently in an article on Seeking Alpha, “Jet Capital on Coking Coal“.

Without the benefit of the MLP structure, the business is simply a money losing coke producer which is trading at a highly inflated EBITDA multiple.

SunCoke currently trades with an enterprise value of around $1.7 billion vs. adjusted EBITDA of $218 million (consensus for 2015). This is an EBITDA multiple of around 8x. But without the benefit of the MLP structure this should drop to around 6x or below. This could see at least $400 million shaved off of the market cap in short order.

More importantly, the current base of holders is heavily skewed towards hedge funds who are holding in anticipation of the future dropdown benefits. They certainly aren’t looking to be long term holders of a money losing coke producer.

It seems clear from the continued weakness in the share price that some of the savvier holders of SunCoke have already started to figure this out.

But there is likely to be around 30-40% more downside once the laggards figure out the implications of the upcoming changes.


Appendix I – text from IRS bulletin 2015-21 Section 1D

The full text of this bulletin can be found here. The relevant section is Section D.

D. Processing or Refining.

Because processing and refining activities vary with respect to different minerals or natural resources, these proposed regulations provide industry specific rules (described herein) for when an activity qualifies as processing or refining. In general, however, these proposed regulations provide that an activity is processing or refining if it is done to purify, separate, or eliminate impurities. These proposed regulations further require that, for an activity to be treated as processing or refining, the partnership’s position that an activity is processing or refining for purposes of section 7704 must be consistent with the partnership’s designation of an appropriate Modified Accelerated Cost Recovery System (MACRS) class life for assets used in the activity in accordance with Rev. Rul. 87-56 (1987-2 CB 27) (for example, MACRS asset class 13.3 for petroleum refining facilities). In addition, except as specifically provided otherwise, processing or refining does not include activities that cause a substantial physical or chemical change in a mineral or natural resource, or that transform the extracted mineral or natural resource into new or different mineral products, including manufactured products. The Treasury Department and the IRS believe that this rule is consistent with definitions found elsewhere in the Code and regulations. See, for example, § 1.613-4(5).


Appendix II – text from US Tax Code §1.613-4 section (6)

The full text of the definitions section can be found here.

See item ( vii) for the definition of “chemical change”

(6) Definitions. As used in section 613(c)(5) and this section:

( i ) The term calcining refers to processes used to expel the volatile portions of a mineral by the application of heat, as, for example, the burning of carbonate rock to produce lime, the heating of gypsum to produce calcined gypsum or plaster of Paris, or the heating of clays to reduce water of crystallization.

(ii) The term thermal smelting refers to processes which reduce, separate, or remove impurities from ores or minerals by the application of heat, as, for example, the furnacing of copper concentrates, the heating of iron ores, concentrates, or pellets in a blast furnace to produce pig iron, or the heating of iron ores or concentrates in a direct reduction kiln to produce a feed for direct conversion into steel.

( iii ) The term refining refers to processes (other than mining processes designated in section 613(c)(4) or this section) used to eliminate impurities or foreign matter from smelted or partially processed metallic and nonmetallic ores and minerals, as, for example, the refining of blister copper. In general, a refining process is designed to achieve a high degree of purity by removing relatively small amounts of impurities or foreign matter from smelted or partially processed ores or minerals.

(iv) The term polishing refers to processes used to smooth the surface of minerals, as, for example, sawing applied to finish rough cut blocks of stone, sand finishing, buffing, or otherwise smoothing blocks of stone.

( v ) The term fine pulverization refers to any grinding or other size reduction process applied to reduce the normal topsize of a mineral product to less than .0331 inches, which is the size opening in a No. 20 Screen (U.S. Standard Sieve Series). A mineral product will be considered to have a normal topsize of .0331 inches if at least 98 percent of the product will pass through a No. 20 Screen (U.S. Standard Sieve Series), provided that at least 5 percent of the product is retained on a No. 45 Screen (U.S. Standard Sieve Series). Compliance with the normal topsize test may also be demonstrated by other tests which are shown to be reasonable in the circumstances. The normal topsize test shall be applied to the product of the operation of each separate and distinct piece of size reduction equipment utilized (such as a roller mill), rather than to the final products for sale. Fine pulverization includes the repeated recirculation of material through crushing or grinding equipment to accomplish fine pulverization. Separating or screening the product of a fine pulverization process (including separation by air or water flotation) shall be treated as a nonmining process.

(vi) The term blending with other materials refers to processes used to blend different kinds of minerals with one another, as, for example, blending iodine with common salt for the purpose of producing iodized table salt.

( vii) The term treatment effecting a chemical change refers to processes which transform or modify the chemical composition of a crude mineral, as, for example, the coking of coal.

The term does not include the use of chemicals to clean the surface of mineral particles provided that such cleaning does not make any change in the physical or chemical structure of the mineral particles.

(viii) The term thermal action refers to processes which involve the application of artificial heat to ores or minerals, such as, for example, the burning of bricks, the coking of coal, the expansion or popping of perlite, the exfoliation of vermiculite, the heat treatment of garnet, and the heating of shale, clay, or slate to produce lightweight aggregates. The term does not include drying to remove free water.







Disclosure: The author was previously an investment banker for a major global investment bank and was engaged in investment banking transactions with a wide range of industrial companies. The author has not been engaged in any investment banking transactions with US listed companies during the past 5 years. The author is not a registered financial advisor and does not purport to provide investment advice regarding decisions to buy, sell or hold any security. The author currently holds a short interest in SXC and during the past 12 months has provided fundamental and/or technical research to investors who hold a short position in the stock. The author may choose to transact in securities of one or more companies mentioned within this article within the next 72 hours. Before making any decision to buy, sell or hold any security mentioned in this article, investors should consult with their financial adviser. The author has relied upon publicly available information gathered from sources, which are believed to be reliable and has included links to various sources of information within this article. However, while the author believes these sources to be reliable, the author provides no guarantee either expressly or implied.


KERX: Watch for an FDA warning letter


  • Keryx has been marketing Auryxia off label conveying a “two for one benefit”.
  • An “iron benefit” is absolutely critical to the successful marketing of the drug, but Auryxia has not been approved for this.
  • Keryx has even marketed the detailed financial savings involved from this unapproved indication.
  • Similar illegal marketing practices by Aegerion quickly led to an FDA warning letter and DOJ investigation and a sharp decline in the stock.
  • I expect a sharp decline in Keryx.

Authors note: prior to publication the author reported Keryx’s marketing practices described below to the United States Food And Drug Administration under their “Bad Ad” outreach program. As a result of the findings below, the author is short KERX.

Company fundamentals

Name: Keryx Biopharm (NASDAQ:KERX)

Market Cap: $1.1 billion

Share price: $9.31

Cash / share: $1.64 per share

LTM Rev: $2 million

Product Rev: $422,000 (net)

Avg Volume: 2-3 million shares / day

Options: Very liquid calls and puts

Keryx recently announced Q1 earnings following the Q4 2014 launch of its only product, which controls phosphorous levels in dialysis patients. Disappointing revenues quickly sent the stock to a new 52 week low as analysts began downgrading the stock.

On Friday, further disappointing weekly prescription data caused the stock to break another 52 week low, hitting $9.28.

Despite the new lows, former CEO Ron Bentsur just filed to sell over 1.5 million shares last week.

(click to enlarge)

Section I: Summary

One of the biggest risks with smaller cap pharma companies who are just bringing their first drug to market is that they are inexperienced and will commit major blunders even after their first drug gets approved.

Some of these blunders, such as illegal marketing practices, are so blatant and obvious that it is difficult to imagine how the executives of a major company could commit them.

Federal and state laws, including the False Claims Act, state that pharma companies may only market drugs based on their “label” as specifically determined by the FDA.

According to falseclaimsact.com:

Although physicians may prescribe a drug for an off-label use, pharmaceutical companies violate federal law, including the False Claims Act, when they market, promote or encourage physicians to use their drugs in an off-label or non-FDA approved manner. Pharmaceutical companies that have engaged in illegal off-label marketing or promotion of their drugs have paid the Government hundreds of millions of dollars as a result of Federal False Claims Act cases

We have seen this before and we can now see this in looking at the marketing practices being used by Keryx Biopharm (KERYX). Keryx just released its Q1 earnings and disappointing revenues sent the stock to a new 52 week low.

Keryx has a single product approved and on the market. The product is Auryxia (prior to launch it was known as “Zerenex”) which is approved for ”the control of serum phosphorus levels in patients with chronic kidney disease on dialysis”. That is the only indication for which it is approved.

However, initially Keryx had been hoping to get it approved for a second indication – on the basis that it can increase iron stores.

In 2014, Management had described the iron benefit as being “critical” to the drug’s sales because it differentiates the drug from its competitors and would allow for considerable cost savings by dialysis centers.

So again, marketing Auryxia on the basis of an iron benefit is crucial for actually achieving sales of the drug.

Not only did Keryx not get that approval, but the elevated iron levels were cited as a safety issue.

Despite the lack of approval for this indication, we can now see that Keryx is marketing the drug as having an iron benefit anyway. In fact, Keryx has continued to state that the iron benefit is what differentiates Auryxia from competitors and that the drug will allow dialysis centers to save $2,000-$4,000 per patient by cutting out the extra injectable iron that is required by IV during dialysis.

This is nothing less than illegal off label marketing. I believe that the FDA and potentially the DOJ will be obligated to act on these findings.

Section II: An important example- what happened to Aegerion ?

A similar instance of illegal off label marketing gives us a good idea of what to expect from the current practices at Keryx. Last year Aegerion (NASDAQ:AEGR) received a DOJ subpoena for similar practices shortly after receiving an FDA warning letter. The company was not only forced to discontinue the illegal marketing, but was also forced to “remediate” – actively communicating to the public what had happened and why it was wrong.

(click to enlarge)

Additional problems sent Aegerion even lower following the DOJ investigation.

Aegerion’s CEO had appeared on Jim Cramer’s Fast Money TV show in June of 2013 and made certain claims about their drug Juxtapid which went well above and beyond its FDA approval.

(Juxtapid is approved only for use as an adjunct to a low-fat diet and other lipid lowering treatments, to reduce specific lipids in patients with HoFH. People with this disease have a decreased ability to remove excess LDL cholesterol (so-called “bad” cholesterol) from the bloodstream.)

KEY POINT: What is most interesting here is that even though these highly visible comments were vastly out of line with Juxtapid’s FDA approval, no one (not the brightest analysts or investors) saw any problem with the comments. In fact, investors simply bid up the stock at the time !

Aegerion’s CEO made a second appearance on CNBC in October 2013, making similar comments. But this time someone reported the segment to the FDA and the FDA quickly reacted with a very serious warning letter. The FDA even went so far as to demand remediation, stating:

Because the violations described above are serious, we request, further, that your submission include a comprehensive plan of action to disseminate truthful, non-misleading, and complete corrective messages about the issues discussed in this letter to correct any misimpressions about the approved use of Juxtapid.

The DOJ quickly followed suit with a full investigation and subpoenas.

At the time, Aegerion was still trading near $60. The stock has since plunged to $20 on these and a variety of other concerns.

Aegerion did cease its illegal marketing practices and did ultimately make public communications to correct the misinformation. Over a year after the initial appearance on Cramer, Aegerion disclosed that it had resolved the FDA issues. But by this time the damage to the stock was already done.

Question: What should we learn from Aegerion ?

Lesson #1: Even though the Aegerion violations occurred blatantly in the public eye, no investors or analysts managed to spot them until an FDA warning letter and DOJ subpoena were issued. Everyone missed what was sitting in plain site.

This is identical to what we see with Keryx.

Lesson #2: Like Keryx, Aegerion was marketing its first ever drug which helps to explain how management could be guilty of such an amateurish blunder.

Lesson #3: The FDA is equally concerned about illegal promotion regardless of where it happens, in the clinic or in the mainstream media.

The FDA subsequently provided a statement to CNBC noting that:

Regardless of the media or venue used to disseminate promotional messages about prescription drugs, pharmaceutical companies undermine the drug approval process and may put the public at risk when they promote drugs for uses that have not been proven safe and effective.

As shown below, we can already see Keryx using multiple different venues to conduct the off label promotion for the unapproved indication.

Lesson #4: Being forced to discontinue the off label promotion can have a disastrous impact on sales all by itself. This is simply because without the promotion the dugs sales will fall sharply.

In addition, this heavy impact is further magnified by the impact of the “remediation”, where the company must go out and actively communicate the facts about the inaccuracies to the public.

Without the ability to convey a quantifiable iron benefit, Keryx will not be able to achieve meaningful sales of Auryxia. The financial impact will be very significant. Keryx itself has made it clear in the past that the “iron benefit” was critical to selling the drug.

Section III: Looking at Keryx and off label marketing

Overvaluation alone is never a sufficient reason to short a stock. Overvalued stocks have a way of becoming increasingly overvalued before they finally break.

It is oddly the case that when a company has zero revenues, it is in fact often the worst time to short the stock because its true prospects cannot be quantified. In the meantime, boundless hope prevails.

Instead, the right time to get short a stock is once it starts to deliver results and those results can then be verified as a great disappointment. The right time to short these stocks is therefore typically on the way down.

Even after a 50% drop from its highs of last year, shares of Keryx Biopharm are undeniably grossly overvalued. The company trades with a market cap of over $1 billion, despite generating its first quarterly net sales of just $422,000 from its only product Auryxia. Auryxia launched in December and has had a full quarter to ramp up sales.

The lackluster launch and disappointing sales are the first catalyst for a further decline in Keryx. The second catalyst will likely be the FDA (and potentially DOJ) fallout from their marketing practices.

Note that Keryx also received royalties of $753,000 in Q1 from Japan Tobacco for JT’s sales of Riona in Japan. These royalties have been running at less than $1 million over the past year and are not expected to make up a substantial part of revenues.

Expectations had been running high for Auryxia last year, with the stock hitting as high as $18, valuing the company at nearly $2 billion. But in Q1, the stock has shown a steady decline of around 30%, coinciding with the launch of Auryxia. Again, Auryxia is Keryx’s only product. The stock now trades for around $9.

What is Keryx doing wrong ?

Given the incredibly low level of sales, it is not surprising that Keryx is putting on the full court press to boost sales in any way that it can. On its Q1 conference call, management noted that it was pursuing “geographic and label expansion”.

We can now see that Keryx has been going too far on the sales effort and has been already engaging in blatant off label marketing of Auryxia.

KEY POINT: Not only is Keryx making these statements in public venues (such as earnings calls and to trade journals) but we can see from the comments below that they are also making these statements to doctors.

Keryx has been conveying that Auryxia has a “two for one benefit” in that it not only has an ability to control phosphate, but that it also has the benefit of increasing iron stores. The unapproved “iron benefit” is being marketed as a distinct competitive advantage vs. alternatives and as a way for dialysis centers to save thousands of dollars per patient.

Yet Auryxia is only approved for a single indication, as follows:

AURYXIA is a phosphate binder indicated for the control of serum phosphorus levels in patients with chronic kidney disease on dialysis.

CEO Greg Madison has already been telling publications such as Fierce Pharma Marketing the following:

As Auryxia works, patients absorb iron, something many dialysis patients need anyway. By using Auryxia over a competing product, dialysis centers can cut out 52% of the extra injectable iron they provide to deficient patients, Madison says–and simultaneously cut down on costs.

The reason that this matters is that Medicare pays a flat rate to the dialysis centers. Any cost savings that they can enjoy from not using IV iron stay with the dialysis center.

In terms of communications with doctors and dialysis centers, Madison also noted that:

Reps will be pushing iron absorption as a selling point with that audience, too, focusing on the fact that reducing the need for IV iron can reduce the risk of overall side effects like anaphylaxis.

Madison even went so far as to quantify the benefit to dialysis centers, saying:

All told, according to Madison, the savings per patient per year from using Auryxia over a competitor range on average between $2,000 and $4,000. He’s confident those figures will boost his company’s new med at a time when patients, providers and payers are taking a closer look at pharmacoeconomics.

References to the use of off label marketing can also be found within comments on Keryx’s recent Q1 conference call.

On the call, management noted that:

We have been able to recognize the differentiation and impact of the Auryxia message through recent market research with target prescribers that have interacted with our sales representatives. The data on this slide gives us confidence that the Auryxia message is being delivered and extremely well received…. On the top of this slide, you’ll see that the majority of nephrologists unaided recall that Auryxia is a unique phosphate binders because of its ability to control phosphate AND increase iron storesAlmost verbatim we have been hearing from physicians the two for one benefit with Auryxia.

Here is the slide to which they are referring. The entire presentation can be found here (although I am expecting that it may be changed following publication of this article). I have saved a copy of it for future reference.

(click to enlarge)

Note that this slide states how the “sales message is resonating with physicians“. It is clear that Keryx is marketing Auryxia as having a benefit for which it is not approved.

Fully 64% of the respondents “recall” that Auryxia impacts Serum Iron. In other words, they are being pitched this benefit in the sales calls.

From page 11 in the presentation we can also see the following slide which explicitly states this benefit.

(click to enlarge)

Item #3 above states that Auryxia “increases serum iron parameters through systemic absorption”. Again, this is how the “iron benefit” of Auryxia is being marketed, but this is not something for which it is approved.

How does Keryx expect to benefit from this off label marketing ?

In the initial launch press release, Keryx had noted that:

End-stage renal disease (ESRD) represents the most severe stage of CKD, as many metabolic factors, such as iron and phosphorus, are out of balance. The majority of ESRD patients require chronic treatment with phosphate-binding agents to lower and maintain serum phosphorus at acceptable levels. In addition, iron can be severely depleted in dialysis patients and they therefore are often treated with intravenous iron and other medications. Approximately 450,000 ESRD patients require dialysis in the U.S., with the number projected to rise in the future.

Note that in its official press release Keryx stopped short of conveying any iron benefit. But from the subsequent notes seen above, we can see that the “benefit” is that Auryxia can be seen as a substitute for intravenous iron. Again, this indication has not been approved by the FDA.

In the past Keryx tried but failed to gain approval for iron indications. Instead, the iron “benefit” was included as a safety warning.

Last year on the Q2 conference call, Keryx stated that

So as we await potential label there, I think iron parameters that we have talked about there are obviously a critical component of that and a potential big differentiator for us in the market place.

Shortly after approval (when the drug was still known as Zerenex), Adam Feuerstein of TheStreet.com had noted that:

As an iron-based phosphate binder, “Zerenex’s” most important advantage – differentiating it from the competition — was supposed to be its ability to reduce the use of anemia drugs like Amgen’s (AMGN) Epogen in kidney dialysis patients. Keryx has long promoted the idea that kidney disease specialists and dialysis providers would flock to “Zerenex” because of the cost savings resulting from fewer injections of Epogen.

But the “Zerenex” label approved by the FDA makes no mention of the drug’s beneficial effect on anemia, nor does the label say anything about reductions in the use of anemia drugs. Sometimes, when FDA doesn’t agree with a company about the desire to highlight a potential drug benefit, regulators will still allow the company to include relevant clinical data in the label. Not this time.

FDA barred Keryx from including any anemia-related “Zerenex” data in the clinical studies section of the label.

KEY POINT: So the key point is that having an iron benefit was critical for the marketing of Auryxia / Zerenex to dialysis centers. Use of it would supposedly result in large cost savings by not needing to use injections of drugs such as Epogen. Keryx did not win approval for an iron benefit, but Keryx is marketing that benefit anyways – claiming cost savings of $2,000-$4,000 per patient.


Keryx is clearly marketing Auryxia as having a benefit for which it was not approved. More importantly, this “benefit” is the key differentiation point for the product. Without being able to make these marketing claims, Keryx will see its already flagging sales crippled.

The FDA has made it clear that illegal off label marketing of drugs will be acted upon, regardless of the venue in which it is done. In the past, the FDA has not only forced offenders to discontinue the practices, but they have also demanded public remediation to clarify the issues to the public.

Keryx has already made clear that its sales reps are sending out the “iron benefit” message to their intended target audience, the dialysis centers and physicians.

Even WITH the off label marketing, sales of Auryxia have been a steep disappointment, pulling in net sales of just $422,000 in its first full quarter following its December 2014 launch.

The former CEO just filed to sell over 1.5 million shares despite the fact that the stock is hitting new 52 week lows.

In the meantime, Keryx is still valued at over $1 billion. But probably not for very long.

Key catalysts for further decline in Keryx:

  • regulatory intervention due to off label marketing practices
  • continued revenue disappointment
  • further analyst downgrades
 Authors note: prior to publication, the author did speak with a medical rep from Keryx who confirmed that there is no iron benefit as part of the drugs label.

Additional disclosure: The author was previously an investment banker for a major global investment bank and was engaged in investment banking transactions with a wide range of healthcare companies including medical device, pharmaceutical, genomics and biotech companies. The author has not been engaged in any investment banking transactions with US listed companies during the past 5 years. The author is not a registered financial advisor and does not purport to provide investment advice regarding decisions to buy, sell or hold any security. The author currently holds a short interest in KERX and during the past 12 months has provided fundamental and/or technical research to investors who hold a short position in the stock. The author may choose to transact in securities of one or more companies mentioned within this article within the next 72 hours. Before making any decision to buy, sell or hold any security mentioned in this article, investors should consult with their financial adviser. The author has relied upon publicly available information gathered from sources, which are believed to be reliable and has included links to various sources of information within this article. However, while the author believes these sources to be reliable, the author provides no guarantee either expressly or implied

AMCN: Air Media Doubles On Sham Investment Transaction


  • Air Media has more than doubled in the past few weeks based solely on an supposed “investment” by A share company Shenzhen Liantronics.
  • Air Media did not disclose the actual contract, but did put out a press release touting a $500 million valuation.
  • The real contract reveals that there is no binding deal. In fact, Liantronics has not even conducted due diligence.Liantronics management has verified key details.
  • We have seen similar “investment” ploys by NQ Mobile and Ping Tan marine which briefly spiked their stocks before they quickly crashed.
  • Air Media should quickly correct back to the $2.00 level from where it started (down by 50-60%).

Definition of “sham” - noun: something that is not what it purports to be;

Investment overview

Shares of Chinese small cap Air Media have jumped as much as 150% in the past few weeks based solely on an announcement that A share listed Shenzhen Liantronics is taking a 5% stake in an Air Media subsidiary, valuing the company at $500 million. But Liantronics is telling a very different story, saying that it hasn’t even conducted due diligence.

(click to enlarge)

Institutional ownership of Air Media stands at just 8.6%. As we can see from various chat rooms and Twitter feeds, the main parties boosting the stock are simply headline focused day traders looking to ride the pop on the “news”. There has been no reference to or analysis on any terms of the supposed deal or even basic analysis of the recently released annual report.

The stock has largely been hyped by such retail day trader sites such as:






Air Media never disclosed the actual contract, but I have obtained a copy and it shows that the deal is very unlikely to go through due to unrealistic clauses which are entirely unachievable. These clauses were deliberately included to protect Liantronics. As a result, Liantronics has also ensured that it has retained full ability to back out of the deal by including a “put option”.

On Friday, shares of Air Media plunged by nearly 20% on high volume in pre-market trading. Traders were left to wonder why. In fact, this was just after the annual report was released on Friday. Investors who bothered to read it clearly found just slight reference to just some of the actual proposed terms being described. For investors who read and understand them, these small references show that the deal basically will not go through at all. Of greater concern is that the worst of these terms are not even disclosed in the 20F at all, nor is the actual contract itself.

The point is that Air Media has no deal.

In fact, we have seen nearly identical “investment deals” in the past for Chinese companies such as NQ Mobile (NYSE:NQ) and Ping Tan Marine (NASDAQ:PME). After an initial surge, the stocks cratered each time. The reason was the same: the reality was that there was simply “no deal”.

It is notable that Air Media had also done a similar “investment” deal in 2013 with a different supplier by the name of Elec-Tech. That deal (perhaps by coincidence) also supposedly valued Air Media at $500 million, but with no lasting effect on the share price once investors read the actual terms.

Had Air Media disclosed the actual contract for the supposed Liantronics deal, the stock never would have risen in the first place. I expect the stock to quickly fall back to around $2.00 where it began before the misleading press release.

This will become entirely clear below.

Part I: Background of Air Media

As recently as April 7th, shares of Air Media Group (NASDAQ:AMCN) were trading below $2.00, valuing the company at just $100 million. Basically it was trading at the value of its cash on hand with no value attributed to the business itself.

As we will see, there are ample reasons for this pessimism towards Air Media.

Air Media is in the advertising business in China, placing ad screens on planes and trains as well as outside of gas stations. The stock took a beating in 2011 because it was in the same space as China Media Express (former ticker CCME). CCME was in the business of placing ad screens on inter city busses in China, but it imploded due to fraud when it was found that many of its screens simply did not exist. Air Media’s stock remained distressed for the past 4 years and never recovered until the past few weeks.

Air Media has lost money every year for the past 5 years and revenues continue to plunge every year. The company recently gave partial guidance that results were set to continue their downward slide, repeatedly citing “a soft advertising market” as the cause for ongoing declines.

(click to enlarge)

In April 2015, the company announced that it had obtained concession rights to provide WIFI service on low speed (“ordinary”) trains on the Shanghai line as well as on high and low speed trains in Jinan. The problem is that Air Media is not making any money off of WiFi.

In the Shanghai press release, Air Media had noted that it already had substantial involvement in WiFi:

Before obtaining the aforementioned concession right, AirMedia was granted concession rights to install and operate Wi-Fi systems on the high-speed trains operated by Beijing Railway BureauShanghai Railway Bureau and Guangzhou Railway (Group) Corporation, with which AirMedia established a leading position in Wi-Fi services on high-speed trains in China, in terms of the number of high-speed trains on which it has concession rights to operate on-train Wi-Fi systems. In addition, AirMedia also holds the concession rights to install and operate Wi-Fi systems on ordinary trains operated by Xinjiang Railway Bureau.

What you need to know: Despite already operating on some of the largest railways in China during 2014, we can see from the annual 20F report that this WiFi business has so far generated so little revenue that it is not even broken out for financial reporting purposes.

For anyone who has reviewed the Q&A most recent conference call, it should be clear that company does not yet have a coherent strategy to monetize the WiFi on trains idea, even though they continue to bid on more and more concessions.

So the first point is that this business has generated minimal revenues so far, even though it requires large concession payments. The second point is that around 80% of the company’s business continues to be comprised of providing advertising on screens in airports (WiFi is still a negligible business).

Airport advertising is Air Media’s primary business and it is why Air Media loses so much money. This just so happens to be the money losing business in which Shenzhen Liantronics is supposedly going to invest. (Note: these financials become very important when viewing the contract below.)

Air Media has also tried to divest itself of its worst money losing units, but these were so also minor in size that they do not move the needle much in terms of achieving overall profitability. This should also be clear to anyone who has read the recent annual 20F report.

Air Media has seen significant turnover in CFO’s, reporting the resignation and replacement of its CFO nearly every year for the past 5 years. In 2011 (just after the implosion of China Media Express), the entire finance team quit at once. Air Media had disclosed that “During the year ended December 31, 2011, we experienced turnover in the chief financial officer, the financial controller, and the financial reporting director and other key positions within the accounting and financial reporting department.”

The point of all of this is simply that there are ample reasons why the stock has historically traded simply at cash value, with investors attributing no value to the underlying business.

Part II: The pump on Air Media – stock doubles within days

On April 8th, Air Media’s stock jumped by more than 40%, suddenly trading nearly $40 million in volume when it announced that Shenzhen Liantronics would invest $25 million for a 5% stake in an Air Media subsidiary. As pointed out by Air Media, this would imply a value for the entire company at RMB 3 billion (equivalent to approx. $500 million).

Liantronics (SHE:300269)is a US$2 billion market cap company listed on China’s A share market. The company manufactures LED advertising displays.

Chinese brokerage firm Sinolink Securities was quick to add fuel to the fire, speculating that Liantronics was angling to buy the remaining 95% of the company and that the implied price would be US$8-10. Air Media quickly jumped by an additional 50%.

It is this speculation (that the entire company will be bought out at $8-10) that has been the biggest cause for the spike in the share price.

As a result of the continued speculation, Air Media have spiked even further. The shares have now more than doubled and have hit 5 year highs.

At the current price, Air Media is valued at nearly $300 million. This is more than double its recent levels, but still only around half of the “implied” investment value as stated my Air Media and Sinolink. Retail day traders who are buying into Air Media still clearly see it as an implied double from here.

Key investment thesis

Air Media will quickly fall by at least 50-60% back to its original level of around $2.00.

What is important to note here is that Air Media only put out a simple press release touting the headline “investment” terms by Liantronics. Air Media did NOT actually disclose the actual contract with Liantronics. Even in the recent 20F filing, the actual contract (which, if real, should have certainly been deemed to be material) has not been disclosed.

There is only an “equity pledge agreement” where Liantronics is not even a signatory. Again, Liantronics has not signed this agreement as disclosed by Air Media.

More importantly, the equity pledge agreement shown by Air Media does not include the key terms of the actual contract. It is these key terms that virtually ensure that there will be no deal for the Air Media subsidiary and that give Liantronics the right to take back all of its money.

The most important point here is that had Air Media disseminated the full contract allowing investors to see the real terms of the deal, the stock never would have risen in the first place.

At best, this transaction may provide a short term loan to Air Media which must quickly be repaid. At worst, the money will never be transferred in the first place

Part III: How do I know the investment by Liantronics is a sham ?

First, because I found a copy of the actual contract via Liantronics. Second, because I actually spoke with Liantronics to get the real information.

The actual contract has not been disseminated in English so no one seems to have found it yet. The research by Sinolink makes no reference to these actual terms and only refers to the press release from Air Media.

For easy reference, readers can flip to the bottom of the contract to see that it is indeed signed by Shenzhen Liantronics and that the date is April 7th, 2015. This is the same date as the announcement by Air Media and is the same date as specified on Air Media’s vague “equity pledge agreement“.

Here is a copy of the Chinese version of the contract from Liantronics.

Here is a copy of the translated version of the contract.

For those who wish to double check, they can also use Google Translateto verify.

Point #1: The inclusion of nonsense conditions means that the deal will never happen

Note: Within the contract, the parties are specified as follows:

Party A:Beijing Shengshi Lianhe Advertising Co. Ltd i.e. the transferor

甲方: 北京盛世联合广告有限公司

Party B: Shenzhen Liantronics Co. Ltd

乙方: 深圳市联建光电股份有限公司

Party C:Air Media Advertising Group Co. Ltd

丙方: 航美传媒集团有限公司

In order for the investment to go through, the contract specifies that the Air Media subsidiary earn an AUDITED PROFIT in 2015 of RMB 200 million. That is equal to approximately US$31 million. If this does not happen, then Liantronics simply gets its “investment” back plus a 10% annual cost of funds fee.

Readers may wish to pause for a moment now and start frantically hitting the sell button.

Because the odds of the sub earning a profit of $31 million are basically zero. It was a “nonsense” condition that was included because it simply allows Liantronics to back out.

It is also worth noting that because the requirement is for AUDITED numbers for 2015, any investment from Liantronics could not even be finalized until after that audit is complete sometime in 2016.

Perhaps of greatest importance is the fact that nearly 50% of the concessions which will be placed into the subsidiary EXPIRE by the end of 2015. This is why Liantronics structured the deal the way they did. Again, this is of key importance. Because it shows that once Liantronics does complete due diligence, there will simply be no way for Air Media to earn a profit of $31 million.

In the contract, it is noted that the “basis for pricing” was the net profit of RMB 200 million (equivalent to US$31 million)

The Basis for pricing:is according to Party C’s 100% stock right, which after the promised audit comes up to a net profit of RMB 200,000,000 in 2015.

In Chinese:


It is also specifically noted that in the event that the transaction is deemed null and void, then Liantronics must be paid back the entire investment plus 10% annualized cost of funds.

Should the authorized decision maker of Party A or Party B regards this transaction null and void due to non-compliance with the decision-making process or other legal reasons, Party A must pay RMB150,000,000 to Party B within 5 working days receiving the notice for repurchasing Party C’s 5% equity, as well as pay Part B 10% of the annual cost of the capital as the payment for the use of the funds, from the very next day when Party A receives the full amount of the transaction under this agreement until the repurchase of the share is completed.

In Chinese:

如本次交易被甲方或丙方有权决策机构因未履行决策程序或其他法定事由 而认定为无效的,则甲方需在收到乙方通知后的5个工作日内以人民币1.5亿元现 金回购乙方购买的丙方5%的股权,并按照10%的年资金成本向乙方支付资金占 用费,占用期为甲方收到本协议下全部交易金额的次日至股权回购完成日。

Air Media has lost money 5 years running. That much is obvious. But we can see by looking at total revenues and concession fees that the sub business can’t possibly earn this much profit (if, in fact, there is even ANY profit at all).

Air Media disclosed during its March conference call that

AirMedia currently expects its net revenue for the first quarter of 2015 to range from US$53 million to US$56 million…… AirMedia currently expects its concession fees to be approximately US$45 million in the first quarter of 2015.

There are two points here. First, revenues are declining significantly. In Q4 last year, Air Media did $65 million in revenues, so they will show sequential decline of around 15%.

Second, we can see that GROSS profit for the entire business, including all of the airport advertising and including the other advertising and WIFI businesses comes to just $10 million per quarter. And this is before SG&A and all other operating expenses. In Q4, SG&A alone ran at $15 million (more than all projected gross profit).

In 2014 (the full year), the GROSS profit of the entire company was just $16.6 million. Selling and marketing alone amounted to $25 million while G&A expenses ran at $26 million. Again, EACH of these is well more than the gross profit for the entire company. For the full year, operating losses amounted to $35 million. After adjustments, net losses still came to $26 million.

The point is that Liantronics set an unobtainable hurdle of RMB 200 million (US$31 million) in profit. It is a win-win for Liantronics. If the sub was somehow able to earn this much money, then it would indeed be a great deal for Liantronics. If not, Liantronics simply gets its money back.

What is important to note here is that because of the “put option” described below, Air Media cannot even use any of the supposed investment money because Liantronics has the right to call all of the money back, plus interest.

To the extent that any money can in fact be received, it is nothing more than a short term loan (pending due diligence) that cannot be used because of the redemption feature.

Point #2: There are two built in “put options” to make sure the deal doesn’t go through

So here is where it gets worse.

Just to be sure that no money permanently changes hands, Liantronics and Air Media also specified that there had to be a two built in “put options”.

The first put option belongs to Air Media and it says that in the event that Air Media finds any different investor within 75 days, then it can simply give Liantronics back its money and cancel the deal.

This is important because it shows that Liantronics is clearly not determined to “buy the remaining 95%” as stated by Sinolink. In fact, Liantronics does not seem to even be very determined to purchase this initial 5%. No party who had any serious intention of buying 5% of a target would allow the target to simply cancel at its own discretion and sell to someone else.

Had Liantronics actually intended to secure a full stake in the Air Media sub, they would a) not have allowed the investment to be called away from them and b) demanded some sort of right of first refusal or option on an additional stake.

But because Sinolink has not seen the actual terms, they are unaware of any of this and have therefore speculated that Liantronics will buy the entire company for $8-10.

The second (more important) put option belongs to Liantronics and it says that even after 75 days, if Liantronics wants its money back, then Liantronics can simply cancel the deal.

This language for the two put options can be found here in a “follow up arrangement”:

The follow-up arrangement:Within 75 calendar days from the date of Party B’s cash payment, Party C shareholders can choose to sell Party C’s equity to a third party investors. However Party C must notify Party B promptly, and after 5 working days after the issuance of the notice Party A will pay Party B RMB150,000,000 to repurchase the 5% equity Party B bought from Party C, as well as pay Party B 10% of the annual cost of the capital as the payment for the use of the funds, from the very next day when Party A receives the full amount of the transaction under this agreement until the day when the repurchase of the share is completed. 75 calendar days after Party B completes cash payment, Party A has no right to request redemption of Party C’s 5% equity bought by Party B, unless Party B requests Party A’s repurchase. Should such circumstance occurs, Party A must pay RMB150,000,000 to Party B within 5 working days receiving the notice for repurchasing Party C’s 5% equity, as well as pay Part B 10% of the annual cost of the capital as the payment for the use of the funds, from the very next day when Party A receives the full amount of the transaction under this agreement until the repurchase of the share is completed.

In Chinese:

5、后续安排:在乙方完成现金支付后的75个自然日内,丙方股东可以选择 将丙方股权出售给第三方投资者,但必须及时通知乙方并于通知发出后的5个工 作日内,甲方以人民币1.5亿元现金回购乙方购买的丙方5%的股权,并按照10% 的年资金成本标准向乙方支付资金占用费,占用期为甲方收到本协议下全部交易 金额的次日至本款规定的股权回购完成日。在乙方完成现金支付后的75个自然日届满后,甲方无权要求赎回乙方已购买的丙方5%股权,除非乙方要求甲方回购, 在此情况下,甲方需在收到乙方通知后的5个工作日内以人民币1.5亿元现金回购乙方购买的丙方5%的股权并按照10%的年资金成本向乙方支付资金占用费,占 用期为甲方收到本协议下全部交易金额的次日至股权回购完成日。

如本次交易被甲方或丙方有权决策机构因未履行决策程序或其他法定事由 而认定为无效的,则甲方需在收到乙方通知后的5个工作日内以人民币1.5亿元现 金回购乙方购买的丙方5%的股权,并按照10%的年资金成本向乙方支付资金占 用费,占用期为甲方收到本协议下全部交易金额的次日至股权回购完成日。

This is why the stock plunged by nearly 20% on Friday

The 20F which came out on Friday had a single paragraph which made reference to the fact that the deal could be cancelled at will. Even though the 20F makes no reference to the $31 million profit condition, this was enough to spook some investors. The stock plunged to nearly $4.00 from $5.00 in pre market trading on hundreds of thousands of shares.

Yet it remains the case that most investors have not figured this out and still think that the deal is “on”.

Here is that paragraph.

In April 2015, Shengshi Lianhe entered into an agreement with Liantronics to transfer to Liantronics 5% equity interest in AM Advertising for RMB150 million. Liantronics agrees to make payments for the transfer after the change in AM Advertising’s equity ownership is duly registered in government records. Before such change registration, we plan to consolidate certain media business lines under AM Advertising through internal re-organization. During the period of 75 calendar days after Shengshi Lianhe receives full payment from Liantronics, or the Waiting Period, we may elect to sell our equity interest in AM Advertising to third parties, and if we so elect, Shengshi Lianhe will repurchase such 5% equity interest from Liantronics for an amount equal to RMB150 million plus applicable fees. The applicable fees will be calculated as 10% of RMB150 million per annum for the period from the date on which Shengshi Lianhe receives Liantronics’ full payment through the date on which such repurchase is completed. In addition, if we elect not to sell to third parties during the Waiting Period, Liantronics may request that Shengshi Lianhe repurchase such 5% equity interest after the end of the Waiting Period. Repurchase price in this situation will equal to RMB150 million plus applicable fees, which will equal to 10% of RMB150 million per annum for the period from the date on which Shengshi Lianhe receives Liantronics’ full payment through the date on which such repurchase is completed.

Part IV: But what does management at Liantronics have to say ?!

In order to gain full clarity on this supposed “investment” and on Liantronics intentions, I held a conference call with Liantronics’s security department regarding the details of the transaction with Air Media.

The key points were as follows:

1. Liantronics has not even conducted any due diligence on Air Media or its subs.

2. $31 million is the required profit target for the business in 2015 after Air Media spins off its gas station media business and airport WiFi business. This is the basis for a hypothetical $500 million valuation.

3. Liantronics does not know undisclosed financial details of Air Media and both parties did not discuss further details.

4. This supposed transaction is entirely still in its initial stage. Even if the deal were to be eventually closed, based on the agreement between Liantronics and Air Media, within 75 days after the closing deal, Air Media has the right to revoke the deal. And after 75 days after the closing deal, Liantronics still has the right to revoke the deal.

5. In the event that Air Media can not finish its spin off and/or can not meet the net profit target in 2015, Liantronics may opt to not close this deal and/or revoke this deal even after its closing.

6. Currently, to Liantronics’s best knowledge, Air Media did not start its spin off process yet and both sides did not resume the continuing negotiation and/or discussion regarding the implementation of the transaction yet.

So basically, there had been discussions, but there is no deal. The state of discussions is so preliminary that Liantronics has not even conducted due diligence. In short, the terms of the deal itself will basically preclude it from happening.

Part V: In China, we have seen identical sham investments before

In all fairness, investors should not be surprised to see this type of sham transaction being used to hype a Chinese small cap. We have seen the same thing repeatedly in the past when beaten down companies are looking to prop up their stock.

The two recent examples that stick out most notably are with NQ Mobile and Ping Tan Marine .

On May 30th, 2014, NQ Mobile announced that it was selling a minority stake in its FL Mobile unit to Bison Capital. The headline terms were nearly identical to what we see with Air Media.

And oh by the way, Bison Capital (the investor behind the NQ “investment”) happens to be one of the only major investors in Air Media. Bison also sits on Air Media’s board. Keep this in mind as you read the details below.

NQ said that it would sell a 5.8% stake for $25 million, which would value the FL unit alone at $425 million. The news sent NQ’s stock soaring by more than 50%, sending it briefly back above $10.

But (just like the Air Media deal), there were certain “conditions” to the deal. There was a “redemption right” (a put effectively) which said that if FL did not complete a qualified IPO within 12 months then Bison gets its money back.

Within weeks, the market began to understand that the investment was a sham and the share price plunged by 50%.

That did not stop NQ from trying again in December. In its second attempt, NQ announced that it was selling 100% of the FL mobile unit for an even greater amount, this time $630 million. But by December, the market wasn’t being fooled again.

It has now been nearly 12 months and there is no IPO in sight. NQ (the entire company) is now valued at just $329 million, with the value of FL mobile being near zero. Just last week, Omar Khan, the Co-CEO decided to step down from is role at the company.

(click to enlarge)

As shown above, shares of NQ are now down by 60-70% since that time.

With Ping Tan Marine (yet another sham investment), the situation was also almost identical. Ping Tan announced in February 2015 that China Agriculture Industry Development Co was investing $64 million to buy an 8% stake. Ping Tan touted that this valued the company at $800 million and the stock (of course) briefly soared to over $3.00 and was valued at nearly $300 million (still a considerable discount to $800 million).

But once investors actually evaluated the actual contract and understood the profit conditions involved, the stock quickly plunged back to lower than where it started.

Ping Tan now trades at less than $2.00 and is valued at just $150 million.

(click to enlarge)

In fact, Air Media itself has done this identical dance before. How did it work out ?

In 2013, Air Media announced that a company called Elec-Tech was acquiring a 21% stake on Air Media’s Great View Media subsidiary for $104million. Elec-Tech is a competitor to Liantronics in the electronic display business.

The acquirer was a supplier to Air Media. As with the current situation, the implied valuation was around $500 million for Air Media.

However, it was then disclosed that 100% of the investment amount from this “investment” had to be used to simply buy product from the supplier. By year end, 50% of the investment amount had already been used to buy displays. It is little more than a line of credit from a supplier.

As disclosed in the 2013 20F,

In May 2013, several entities affiliated with AirMedia, including GreatView Media, the primary operating entity of our gas station media network, and its then-existing shareholders, entered into an investment agreement with Elec-Tech International Co., Ltd., or Elec-Tech. Pursuant to the investment agreement, Elec-Tech agreed to invest RMB640 million (US$104 million) to purchase ordinary shares representing approximately 21.27% of the equity interest of GreatView Media. After the completion of the transaction, AirMedia controls 61.41% of the equity interest of GreatView Media and the senior management team of GreatView Media indirectly holds 17.32% equity interest in GreatView Media through Zhongshi Aoyou, which is wholly owned by the management team. Pursuant to this agreement, the then-existing shareholders of GreatView Media agreed to cause GreatView Media to utilize Elec-Tech’s contribution for the sole purpose of purchasing LED screens from Elec-Tech or its subsidiaries. As of December 31, 2013, GreatView Media purchased 1,000 sets of LED screens in total from Elec-Tech for our gas station media business in the amount of approximately US$57 million.

Despite the completed investment valuing Air Media at over $500 million, the stock continued to trade for around $2.00 until this latest “investment” was announced and promoted in 2015.

The point is that “the devil is in the details”. The “investment” by Elec-Tech was also little more than a loan and in no way justified an increased valuation for Air Media.

Part VI: Conclusion

The only reason why Air Media has more than doubled is simply because of a supposed “investment” by Shenzhen Liantronics which ostensibly values the company at around $500 million. The supposed investment deal is not what it has been purported to be.

The supposed investment by Liantronics into Air Media is a sham transaction. It can be simply cancelled by either party and it is contingent upon Air Media’s subsidiary earning an impossible profit level. The transaction was deliberately designed so that it would never end up going into effect and that it could be easily reversed at any time.

This becomes more obvious in light of the fact that nearly 50% of the airport concessions will expire by the end of 2015.

As a result, there will be no lasting investment. If any proceeds are received by Air Media, they will simply be repaid due to failure of the terms required.

Common sense should tell us that the contract is neither certain nor material. If it was, Air Media would have been forced to disclose the actual contract itself as an attachment to the 8K and 20F.

But the market has clearly reacted as if the contract were very real and very material, adding nearly $200 million in market cap to the company’s value within the past 2 weeks.

We have seen identical surges before based on nearly identical sham contracts with companies such as NQ Mobile and Ping Tan Marine. These surges have always shown violent reversals once investors figure out the real terms of the supposed deals.

So now investors should watch for a rapid reversal in Air Media’s share price, with the stock quickly headed back to $2.00 from whence it began.

Authors note: Last week I had attempted to discuss these issues with management by phone prior to publication without success. Shortly before publication, I did receive an email back from management with answers to several questions. I did not tell them I had a full copy of the contract or that I had spoken to Liantronics.

Management stated that they are confident that AM Group Co (the subsidiary) can reach the profit goal of 200 million RMB and that there will be no consequences if they do not. This appears to contradict both the written contract as well as the statements from Liantronics, which are consistent with one another.

As to possible cancellation of the transaction, management stated that it has the right for 75 days to sell equity to a third party and cancel the investment from Liantronics. That is straight out of the contract.

They also pointed out that the investment would be cancelled if it were not paid by Liantronics within 30 days of the transfer of equity. Again, that is also straight out of the contract.

However, in terms of Liantronics right to cancel the deal, management simply stated that

“There is no specific terms and conditions under current transaction agreement as to the conditions when Liantronics will cancel the transaction;”.

This statement is inconsistent with both the contract and with statements from Liantronics. More importantly, it is inconsistent withstatements from Air Media’s own 20F filing, which state that after 75 days Liantronics can require repurchase of the entire investment. This can be for any reason, (including failure to meet the profit target).

Again, as shown above, from the 20F filing:

“In addition, if we elect not to sell to third parties during the Waiting Period, Liantronics may request that Shengshi Lianhe repurchase such 5% equity interest after the end of the Waiting Period. Repurchase price in this situation will equal to RMB150 million plus applicable fees, which will equal to 10% of RMB150 million per annum for the period from the date on which Shengshi Lianhe receives Liantronics’ full payment through the date on which such repurchase is completed.”

I also asked when Air Media expected to receive any proceeds. Management simply quoted the press release, simply stating “Liantronics will pay the proceeds within ten (10) business days once the transfer and registration formalities with government authorities are completed;”.

This article is tagged with: Short Ideas

Forcefield Energy: Undisclosed Promotions And Connections To Past Frauds


  • Heavily promoted by multiple paid promoters (including undisclosed).
  • Stock has spiked to an all time high.
  • Company is out of cash and is delinquent in its filings.
  • Management with close connections to past frauds.
  • Expect a very near term financing to drop the stock by at least 30-40%.

Short Thesis

This is not an article about Forcefield’s business. It is about paid stock promotion and connections to past fraudulent activity.

Forcefield Energy (NASDAQ:FNRG) is a paid-for stock promotion targeting retail investors. Institutional investment in the company totals just 1% of outstanding shares. Forcefield is a company which is out of money and clearly needs to sell stock in the very near term. There has been a flurry of promotions over the past few weeks and months indicating that a financing is likely imminent.

The promotions have worked and the stock is now hitting all time highs on increased volume.

Management members have close ties to past fraudulent companies and activities.

Meanwhile the company has still not filed its annual report (form 10K). As soon as the 10K is filed (potentially within days), Forcefield will take advantage of the share price run up to issue a large amount of stock. The stock will likely trade back to around $3.00-$4.00 in the near term.

Forcefield is currently running on fumes. As of its most recent financials, Forcefield had just $500,000 in cash. It had been reported that Forcefield had sold its interest in TransPacific Energy for $2.0 million. However it was the case the Forcefield only received $50,000 in cash. The remaining $1,950,000 was in fact just hypothetical. The “buyer” simply returned its shares of Forcefield (which had been owned by the buyer) which were then simply cancelled by Forcefield. The cancelled shares are worth nothing and cannot be resold. As a result, Forcefield only received $50,000 not $2.0 million.

Forcefield has never been cash flow positive. Its only source of cash has been the issuance of new shares. Forcefield recently completed several new acquisitions using stock. These acquisitions will increase expenses and cash burn, such that Forcefield will need to raise substantial proceeds as soon as the delinquent 10K is completed.


In the past there has been some debate about the validity of the business at Forcefield Energy . After several failed iterations in the past, Forcefield’s most recently adopted line of business is the installation of LED and other energy efficient lighting.

Critics of Forcefield’s business model mostly share the same concerns as critics of comparable LED installer Revolution Lighting (NASDAQ:RVLT). Revolution once traded as high as $5.00 (a valuation of over $700 million), but has since plunged 80% to around $1.00. Revenues have continued to build strongly for Revolution, but net losses have increased even more. Despite the headline enthusiasm for the major shift to LED lighting, there is simply too much competition in this low margin business to ever realize a profit.

(click to enlarge)

Revolution currently has a market cap of around $150 million based on quarterly revenues of $27 million. Meanwhile (following the stock promotion) Forcefield also has a market cap of around $150 million despite quarterly revenues of just $2 million. On this basis alone, it is clear that Forcefield has a long way to fall.

In fact, prior to a recent acquisition, Forcefield had no material revenue. The recent revenues are simply the result of acquiring an existing installer (which was acquired for stock) which already had revenues.

Like Revolution, the primary catalyst which has driven the stock up has been the repeated partnerships being announced with companies that might allow Forcefield to expand its sales. But as we can see from Revolution, even obtaining massive sales in this business still does not allow for even remote profitability.

Note in the chart below that revenues at Revolution have grown massively from $4 million to $77 million in 3 years. Yet profitability is as elusive as ever. This is why the stock price is down 80% from its peak.

(click to enlarge)

But again, this is not an article about Forcefield’s business model. It is an article about a paid stock promotion and connections to past fraudulent activity.

The history of Forcefield

Forcefield began its life as a Chinese reverse merger known as SunSi, focused on the manufacture in China of a certain chemical used in the production of polysilicon. Note that this is NOT simply the history of the shell company. The Chinese SunSi was run by current Forcefield management David Natan and Richard St. Julien, who still run the company today.

The Chinese activities failed to produce meaningful results. More importantly, in 2011 Chinese reverse mergers became uninvestable due to rampant fraud in the space. There was clearly no money to be made by running a Chinese reverse merger.

As a result, Natan and St. Julien simply changed the name of the company and moved its nominal operations to Costa Rica as they searched for a new business definition.

The company’s next venture was via TransPacific Energy, making “Organic Rankine Cycle” units to maximize heat recovery and minimize waste. After a back and forth fraud lawsuit, Forcefield sold TransPacific back to its original owners for $50,000 cash and the return of stock.

Most recently, the company is now in the business of being a distributor of LED lighting which it buys from a single manufacturer in China. In March of 2013, the company formed a subsidiary in Costa Rica. Up until its recent acquisition of American Lighting (“ALD”) the company had noted that “All of the Company‘s long-lived assets are located in Costa Rica.”

You may ask “why Costa Rica ?”. That will become clear later in this article.

The bull thesis on Forcefield is that it has bid on over $100 million worth of lighting jobs. The bull case states that if the company were to realize even a fraction of that pipeline, it would send the stock sharply higher.

First off, we should again note that Revolution is already doing $76 million in sales without coming close to turning a profit. Yet that company is only valued at $150 million.

But there is something else that isn’t right here either. A full $95 million of this supposed “pipeline” is comprised of a single job which Forcefield bid on but which has yet to be fulfilled. Aside from that, all remaining hoped-for jobs total just $5 million. It is next to nothing.

The $95 million job is simply a red herring designed to prop up the share price. And so far, promoters have successfully used this to run up the share price. We will see more about this below.

Forcefield and stock promotions

In the past, Forcefield was a Dream Team client. The Dream Team was a firm that got paid to write undisclosed paid articles, which were edited and approved by management teams of their clients. The retail targeted articles were designed to prop up the share price and volume so that companies could issue stock to raise money. The scam worked exceptionally well.

But now there is a new generation of different promoters which uses a variety of techniques. What we can see is clear evidence of recent promotions at the precise time when Forcefield needs to issue stock to raise money.

This creates two immediate concerns.

First, the share price is artificially way too high as a result of the promotions.

Second, the stock is about to head sharply lower due to an upcoming and much needed financing.

In the near term I expect to see Forcefield hit $3.00-4.00. Over the longer term, it should trade substantially lower.

Before getting into the current round of promotions, it is useful to review Forcefield’s involvement with the Dream Team Group.

Back in 2014, I wrote a detailed article about stock promotion firm “The Dream Team Group” which was hiring out writers to conduct undisclosed paid promotions on small cap companies. The writers would pretend to be well qualified industry experts putting forth a professional analysis (and a strong buy) on a stock. In fact they were simply hired gun writers with no credentials whatsoever. Yet their professional writings invariably caused their target stocks to soar. The authors managed to infiltrate a wide variety of locations including Forbes.com, TheStreet.com, Seeking Alpha and the Wall Street Cheat Sheet.

To gain information, I posed as a paid stock promoter looking to write undisclosed paid articles. The chief writer for the Dream Team (Tom Meyer) then began giving me assignments.

The main stocks I wrote about in this promotion scandal were Galena Biopharma (NASDAQ:GALE) and Cytrx (NASDAQ:CYTR), both of which ended up plunging by as much as 50-80% when the promotions unraveled. Cytrx has rebounded some, while Galena has continued to plunge.

But there were other companies which I did not give as much attention to because they were too small or illiquid to matter at the time. (Although I did not write about many of these stocks, I did notify all of the various websites such as Seeking Alpha, TheStreet.com and Wall Street Cheat Sheet so that they could remove any articles and ban any violating authors).

Forcefield Energy is one such stock. At the time it was one of a number of beaten down illiquid stocks which didn’t seem to be catching the promotional wave. But now it appears that the continued promotional efforts have resulted in the stock hitting all time highs on much greater volume. This is all occurring just as the company needs to raise money.

Forcefield was a paid Dream Team promotion which was written about by both Tom Meyer (multiple aliases including Wonderful Wizard and others) and John Mylant. These were the two main Dream Team writers. Their articles have since been removed from Seeking Alpha, but the original references can still be found in various places. In addition, Forcefield is listed here among the other Dream Team clients on the Investors Hub page for Mission IR. Mission IR was the Dream Team subsidiary responsible for handling the paid articles.

Mr. Meyer was also attempting to recruit me as a paid writer specifically for Forcefield. Forcefield was an ongoing project of his.

It should be kept in mind that the standard process was for these writers was to submit their drafts to management at the target company for review before publishing. In other words, management of these companies knew and encouraged the illegal stock promotion as a way of getting their share prices up.

But now it seems that a variety of other promoters have taken the helm from the now defunct Dream Team Group.

One such promoter is “Goldman Small Cap Research” (no connection to Goldman Sachs). As it turns out, Tom Meyer from the Dream Team was moonlighting for Goldman Small Cap Research in addition to working for the Dream Team. Tom informed me that the primary advantage of writing articles for Goldman Small Cap Research was that he gets paid with money orders made out to “cash” such that he could avoid paying taxes or being traced.

Tom had assigned me to write an article for Goldman Small Cap on LiveDeal (NASDAQ:LIVE), which I sent to him for his review and for company approval. Tom had been writing his articles for Live Deal using a female alias by the name of Christine Andrews at places such as TheStreet.com and Wall Street Cheat Sheet. (Those sites were informed and those articles have since been removed)

After I submitted my article, Tom responded with edits and a new title. This is a copy of the edits provided to me by Rob Goldman for an undisclosed paid article on Live Deal which was requested to appear on either TheStreet.com or Seeking Alpha. Goldman Small Cap continues to engage in paid promotions for Live Deal, as shown. (Note: I never accepted payments for any articles and I saw to it that none of the draft articles would ever be published).

The point of all of this is simply that Goldman Small Cap is a pay to play research firm used for hyping microcap stocks.

So now let’s see how Goldman Small Cap covers Forcefield Energy.

Tom, along with Dream Team’s John Mylant, both had previously written multiple articles on multiple sites on Forcefield, touting it as a strong buy. Goldman Small Cap has now taken over directly for Tom and just a few weeks ago released a report on Forcefield, hyping the company with a $10 target, stating:

ForceField Energy has recently achieved a new 52-week high on strong volume via the strength of very favorable news on the business development front and appears primed to continue this trend. A diversified green energy provider, FNRG’s recently acquired subsidiaries enable the Company to serve as distributors, installers, and managers of large scale LED lighting projects for Fortune 500 companies. Since FNRG does not produce its own products, it can offer best of class solutions and not be subject to current and potential gross margin deterioration of a commoditized product like LED lights, that may plague other companies. Moreover, its “No Money Down” project financing approach has already garnered sizable deals and a hit list of over $100M worth of potential projects in its pipeline, via active bids. This innovative model typically fosters greater than industry standard top-line growth and valuation.”

(Notice the focus on the $100 million worth of projects with no mention of the fact that $95 million of it comes from one speculative hoped-for project).

We can see from the past that coverage of Forcefield by Goldman Small Cap has been extensive, with at least 20 different notes and reports.

Promoter number three: In addition to the Dream Team (Tom Meyer) and Goldman Small Cap, Forcefield is also being promoted by Mark Bonnaci’s SmallCap Street promotion machine. Small Cap also uses the name Cap Rock.

Perhaps not by coincidence, Small Cap Street is also currently co-promoting Live Deal along with Goldman Small Cap. Their report on Forcefield came in February and cites as a source for info (in small print at the very bottom) Goldman Small Cap Research.

Small Cap Street was recently highlighted for promoting an OTC marijuana stock called Growlife (OTC:PHOT) which was halted by the SEC as a fraud and which has since plunged to just 2 cents. In that article, the same author sheds light on a different stock promotion by Small Cap Street called Provectus (NYSEMKT:PVCT) which has since plunged by 80%. The point is that having your stock promoted by Small Cap Street / Small Cap IR is a sure sign that there is a promotion campaign going on, elevating the stock price to unnatural levels.

Promoter number four: Ultimate Stock Alerts uses the technique of associating the name of Forcefield with larger much more liquid stocks in various press releases posing as news articles, such as this one featured on MarketWatch. The article pretends to be a research note highlighting 3 great stocks: Organovo (NYSEMKT:ONVO), Bind Therapeutics (NASDAQ:BIND) and Forcefield. In fact it is clear from reading this article that the purpose of mentioning these other stocks is simply to hijack their high traffic hit rates and draw attention towards much smaller Forcefield. Ultimate was paid $35,000 to get this note posted on MarketWatch posing as a research article.

The names listed above are the heavyweight promoters, but there are other lightweight promotions going on nearly every week. This includes paid mentions at “US Markets Daily” and “Journal Transcript“.

Message board promotion: There is also an ongoing campaign to populate message boards (such as Yahoo) with bullish messages about Forcefield. This has proved to be a very successful method of luring in retail investors.

Here is one example taken from the message board for Neogenomics (NASDAQ:NEO). The strategy for these posters is to seek out companies whose share price has risen strongly and which are getting a lot of attention. The posters then seek to draw readers’ attention to Forcefield. Some small portion of the readers end up buying into Forcefield, elevating share price and volume. Surprisingly, this strategy can work if there are thousands of postings to other high performing and high interest stocks.

(click to enlarge)

The way to find these postings is to simply look for stocks which are spiking up on high volume. The Forcefield postings can often be found there. Aside from Neogenomics, we can see the same thing on the Biotime (NYSEMKT:BTX) message board and on the Chanticleer Hooters (NASDAQ:HOTR) board among many others. None of these companies have anything in common with Forcefield or its purported energy / lighting business.

Paid email promotions: Forcefield is also the subject of several paid email promotions targeting retail investors. The most recet of these consists of a paid promotion via “Penny Stock Prophet” which began this week. PSP was paid $15,000 to send out these promo emails, which (of course) cite Goldman Small Cap Research as their source. More information and the full promo can be found at pennystockprophet.com

It is no coincidence that this flurry of promotional activity is all happening at the same time for a company which happens to be out of cash. Because Forcefield is delinquent with filing its 10K, it is likely not able to issue stock right now. But as soon as the 10K comes out (likely within the next few days), we should expect a large equity offering to drop the stock back down to around $3.00-4.00. The timing of all of this promotion should be seen as no coincidence.

Again, the dual concerns are that a) the share price has been elevated to artificially high levels and b) the stock is about to crash based on a badly needed upcoming equity offering.

Past connections with past fraudulent activity

In reality, the notion that Forcefield is being promoted before an equity raise should come as no surprise. Aside from their history of using the Dream Team to promote their stock, Forcefield’s three top managers all have extensive ties to past fraudulent companies which have gotten into substantial trouble, including investigations by the SEC, FBI, the US Senate and the Canadian Federal Government.

Forcefield is run by CEO David Natan. Notably, Mr. Natan does not name any of his past companies on his official bio. We can now see why.

From Bloomberg we can see the detailed history of Mr. Natan and his lengthy history of working with promotional companies based out of Boca Raton. For those who don’t know, Boca happens to be the center of stock promotion (and sometimes fraud) in America.

Further digging shows that his past companies are mostly bankrupt former pink sheets companies based out of South Florida, such as MBf, Global Technovations and IMX Pharma.

Just prior to running Forcefield / SunSi, Mr. Natan was CFO of a company called SFBC and he was the one responsible for signing off on their financial statements.

SFBC was basically a south Florida recruitment mill for finding subjects (often illegal immigrants) to act as guinea pigs in clinical trials for drugs that had not yet been approved by the FDA. A lengthy and scathing exposé on SFBC can be found on Bloomberg entitled “Big Pharma’s Shameful Secret” and it is well worth reading. Anyone who has an interest in pharma or clinical trials should absolutely read that article. In the wake of this exposé, SFBC’s share price fell by as much as 75%.

According to the fraud complaint filed in the District Court of New Jersey, SFBC told investors that it had a new state of the art facilitywhich would drive the majority of revenues going forward. In fact, the building was nothing more than a dilapidated former Holiday Innthat

was so structurally unsound that the Miami Dade County Unsafe Structures Board has since ordered the facility to be demolished

It was fraud, plain and simple.

The fraud case goes on to state that

SFBC risked its reputation and recruitment ability by utilizing a variety of unethical and dangerous practices that severely compromised the integrity of the drug trials conducted by the Company. For example, as detailed below, SFBC violated applicable minimum waiting requirements, used deceptive payment schemes to decrease the likelihood that a participant would report adverse reactions to the drugs being tested, failed to put into place adequate controls to prevent participants from applying to concurrent drug trials at other facilities, and failed to ensure that participants – the majority of whom are low-income individuals who speak English, if at all, as a second language - provided the required “informed consent.”

Further, in order to ensure that SFBC’s improper and unethical practices remained hidden from public view, the Company hired regulatory companies that were completely beholden to SFBC and its employees. For example, throughout the Class Period, SFBC paid hundreds of thousands of dollars to a regulatory company called Southern Institutional Review Board (“Southern IRB”) – a supposedly independent review board (“IRB”) – to oversee and “approve” a substantial portion of their clinical tests. Southern IRB was owned and operated by the wife of a senior officer of SFBC. Similarly, SFBC utilized LeeCoast IRB to supervise its tests, despite the fact that LeeCoast IRB was owned by an SFBC subsidiary and employees of LeeCoast were paid directly by SFBC with checks prepared by SFBC’s own accounting offices.

Clearly the goal of all of this was to prop up the stock so that money could be raised. And that plan worked quite well.

Defendants’ untrue and misleading statements and omissions allowed SFBC to project the appearance of growth and success, which inflated the price of SFBC’s securities and enabled the Company’s insiders to enrich themselves at investors’ expense. Indeed, during the Class Period, the individual defendants sold significant portions of their SFBC stock, generating tens of millions of dollars in personal profits. They were also able to orchestrate two large secondary offerings of SFBC securities, which allowed the Company to raise a total of approximately $250 million from unwitting investors.

Insider sales were large. As noted in the Sought Florida Business Journal, “SFBC execs pull in $15.71M from stock sales“. This was just shortly before the fraud came unraveled and occurred before the stock price collapsed.

CEO Natan isn’t the only one with connections to fraudulent companies in his background. Like Mr, Natan, Chairman Richard St-Julien refrains from actually naming any of his past ventures or employers. He simply notes in his bio that

Richard has a great deal of success and experience as a practicing attorney in the areas of Commercial and International Law. In addition, Richard has been involved in numerous business ventures as an entrepreneur in Canada, the U.S., China and other countries.

In reality, it is a bit more colorful than that. Mr. St. Julien appears to be an expert at moving money around in places such as (again, no coincidenceCosta RicaCosta Rica is, of course, where Forcefield ended up establishing its operations and where 100% of its assets were located until 2014.

In 2009, Mr. St. Julien was working as a lawyer in Costa Rica helping to funnel cash to and from convicted fraudster Jean LaFleur who was running a fraudulent scheme in Belize.

The Canadian federal government was suing LaFleur for $7 million for his role in a government sponsorship scandal. According to the Globe and Mail:

Federal lawyers allege in the court documents that Mr. Lafleur “tried to liquidate his assets when it became obvious that [the government]would undertake legal action to recoup money that it had paid to [Mr. Lafleur]as part of his fraudulent scheme.”… Mr. Lafleur said as part of his bankruptcy proceedings that he called on Mr. St-Julien to invest the money on his behalf in Liechtenstein, the Caribbean and Belize….Mr. St-Julien is a member of the Quebec bar, but he is working in Costa Rica, and has refused to explainwhat happened to $460,000 from the house sale that was invested in his Belize company, Parameter, which is now insolvent.

LaFleur was ultimately sent to prison for his role, but the money disappeared.

As for Forcefield’s CFO, Jason Williams, he notes on his bio that he was previously at Protective Products of America (OTCPK:PPAFQ), which happens to be a pink sheets company that trades for less than 1 penny. Not surprisingly, Protective was based in South Florida. In the 3 years that it traded as a publicly company, Protective never filed a single financial statement, so it is unclear what Mr. Williams actual duties might have been at that company. (At Forcefield, financial statements have been delinquent in each of the past 3 years, again raising doubts about his role as CFO).

But it gets better.

Prior to that, Williams notes that at PharmaNet he was an integral part of the management team that facilitated a market capitalization rise from $150 million to $800 million during a three year period. It does sound impressive.

However, this bio fails to mention some key facts. Most importantly PharmaNet is in fact the same SFBC that settled fraud charges two years after the Bloomberg article.

Yes in fact the stock did spike to a valuation of over $800 million during the tenure of Mr. Williams. But that was before it cratered to as low as $50 million (down 85%) in the wake of the Bloomberg fraud exposé.

I would encourage readers to re-read the fraud case against SFBC and its management to fully appreciate its implications.

From the introduction of the fraud case:

This is a case about a company that repeatedly misled investorsabout the most fundamental aspects of its business and operations. That company is SFBC, and throughout the Class Period, SFBC and its senior officers told investors that SFBC was a well-run business with highly-qualified management and significant competitive advantages in its field. In reality, however, SFBC suffered from a raft of undisclosed problems that infected its business and threatened the Company’s very survival.

After the US Senate launched an official investigation into the company, they simply began running their clinical trials in Canada.

You can read about the name change and the move to Canada in this article.

Troubled SFBC changes its name in hope of changing its fortunes

The point of this is that all three top managers have substantial ties to companies with fraudulent activities in the past. They are now all working together in a fledgling company that is hitting all time highs even as there are obvious signs of stock promotion. And of course, the company happens to be out of money.


Forcefield Energy is a stock promotion pure and simple. The company has been engaging paid promoters to issue a series of upbeat reports on its prospects which has successfully powered the stock higher. Some of the reports on Forcefield have made use of undisclosed promotions pretending to be independent authors. Since this time last year, the stock has nearly doubled off of its lows and volume has increased several fold. This is a reflection of the success of the promotions.

Management has a troubling history of involvement with fraudulent companies, misleading investors and the ability to shift money around in international locations such as Costa Rica, where Forcefield continues to maintain the bulk of its operations.

The hype surrounding Forcefield continues to focus on “$100 million” worth of projects being bid on, while ignoring the fact that a single white elephant project accounts for $95 million of the supposed pipeline.

With Forcefield running dangerously low on cash, the timing of the recent flurry of hype and promotions becomes clear. Forcefield has still not filed its annual form 10K (it is delinquent). But as soon as the 10K comes out (any day now), Forcefield will end up issuing a large amount of equity. This will be the catalyst for a very sharp drop in the share price to $3.00-4.00 or below.

Note: The author did attempt to contact Forcefield management, however calls to their corporate office were not returned.

AMCN: Why is Air Media Falling ?


  • Air Media rebounded on Tuesday as retail investors “played the bounce” in anticipation of a company response.
  • After the company responded on Wednesday, the stock opened lower, traded down and closed at the lows of the day, down 12%.
  • Air Media has now disclosed new information which is pressuring the stock.
  • We can now see clearly if there is a “deal” or “no deal”.
  • What about the WiFi business ?


Last Friday (several days before I wrote about it), shares of Air Media (NASDAQ:AMCN) fell by around 20% on heavy volume in pre-market trading. It happened to be immediately after the release of the company’s annual report. It appears that someone out there actually bothered to read the annual report. But shortly thereafter, retail day traders pushed up Air Media’s stock on continued speculation about a potential “deal” to acquire the company. The stock closed flat on that Friday. But traders were clearly a bit shaken.

On Tuesday, I highlighted at moxreports.com the fact that Air Media “had no deal” with Shenzhen Liantronics. It was solely the belief in that deal that had propelled the share price upwards by as much as 150% in just a few weeks. To the extent that there was no deal, the stock should be expected to fall by at least 50%, back to around $2.00. This is just common sense.

Following release of my article, the stock fell by as much as 14%, but rebounded to close basically flat on the day.

As far as I can tell from Chinese trading sites such as xueqiu.com, the buying came from Chinese retail buyers who expected a strong response from the company.

As expected, Air Media did put out a response to my article on Wednesday. The company’s PR was entitled “AirMedia responds to false allegations“. It did not mince words in saying that:

The Company believes that the allegations and accusations set forth in the article are false and inaccurate and contain numerous errors of facts, misleading speculations and malicious interpretations of events.

As soon as the PR was released, the stock opened lower. It traded steadily downward and closed at the lows of the day, down 12%. The drop looks set to continue.

The reason the stock fell is that some investors actually bothered to read the contents of the press release. Despite the confusing and reassuring verbiage in the PR, we can see that: a) there is no deal; and b) new (and potentially greater) issues of concern have been revealed.

As shown below, the stock continues to be heavily held by retail investors (particularly in China) who have clearly failed to read the actual disclosure. The bet is simply one based on speculation of “deal” or “no deal”.

There are 5 key problems which were raised from the response PR, and which are causing the stock to now decline. Although some retail investors can be slower to catch on as they grasp these problems, Air Media is likely to see a much more rapid decline.

Problem #1: What about the “due diligence”?

In its response to my article, Air Media noted the following:

The claim that Liantronics has not even conducted due diligence in connection with the Transaction is erroneous. In contrary, Liantronics engaged a major PRC accounting firm, a recognized PRC law firm, a qualified PRC assets appraisal company and a recognized PRC financial advisory firm to conduct due diligence of AM Advertising in March 2015.

I have no doubt that Liantronics has engaged an accountant. I have no doubt that Liantronics has engaged a law firm. I have no doubt that Liantronics has engaged an asset appraisal firm. Of course they have. Duh.

So why do I say that Liantronics has not done due diligence?

It is… well… um… because Liantronics told me so.

In fact, to emphasize this point, Liantronics was good enough to contrast Air Media with a different situation where they actually HAD completed due diligence resulting in a real deal. We can see from this deal what it would actually require for Air Media to get a deal out of Liantronics.

On the same day (April 7th) as the original Air Media PR, Liantronics announced that it had completed a transaction for a very different media company, Shenzhen Precise Focus Media 深圳市精准分众传媒有限公司(no relation to the former U.S.-listed Chinese company called Focus Media).

In that case, Liantronics had completed due diligence (yes, Liantronics told me so) and found that its target was: a) profitable; and b) growing rapidlyyear-over-year. Liantronics announced that it acquired a 28.4% stake in Precise Focus for around $12 million. We can see the parts about the profits, profit growth and profits targets in the announced key deal terms.

Key Point: If you believe that Air Media’s advertising sub will earn $31 million in 2015, then you should believe that this deal will ultimately go through. If you believe this, then you should buy Air Media stock with both hands, and do not stop until it hits around $6.50.

Precise Focus is very different from Air Media

The point to be made is that Liantronics’ basis for the pricing, even on just a tiny 5% stake in Air Media, was that the Air Media sub earn an audited profitof $31 million in 2015. Otherwise, Liantronics has the full right to simply cancel the transaction.

Unlike Precise Focus, Air Media has been losing money for 5 years. Unlike Precise Focus, Air Media’s business has shown continuous declines in revenues. Unlike Precise Focus, Air Media has already given partial guidance that revenues are set to decline further. Of greatest concern is that nearly 50% of Air Media’s concession rights will expire by the end of 2015, with aggregate concession fees of over $400 million. These are the reasons why Air Media is looking to get out of this business.

These are also the reasons why Liantronics will not end up buying the Air Media sub (once due diligence has actually been done and financial results are in for 2015).

On April 7th, Air Media told us: “AirMedia Sells 5% Equity Interest of its Advertising Business for RMB150 million”.

This statement was wrong. It was factually incorrect. It was erroneous. There had been no binding or completed deal.

The point is that Liantronics has not even done due diligence. In contrast to the April 7th press release from Air Media, there is no deal. It is something that is to be considered by Liantronics once they have actually done the due diligence and come up with acceptable financial numbers.

So the question now becomes: “Will there be an eventual deal?” Read on.

Problem #2: What about the $31 million in profit?

In its original April 7th press release announcing the deal, Air Media failed to mention the fact that the basis for pricing on the supposed deal was a net profit of $31 million. The company gave the impression that this 5% stake was a “done deal”.

Key Point: If Air Media had mentioned this $31 million profit term in its original press release, the stock would have never shot up in the first place.

In its more recent response to my article, the company addressed many points that I made, but quite notably stopped short of saying anything about the $31 million profit as the basis for pricing. The fact that Air Media said nothing in its response PR about the $31 million profit target is a key reason why the stock fell by 12%.

Air Media did state that once the company divested several money-losing business lines, it “believed” the sub would be profitable (to some extent). But that statement should be in doubt even with just cursory analysis of those tiny divestitures. This should be fairly simple.

The two businesses in question are: a) TV-attached digital frames; and b) airport digital TV screens.

Back in April 2014, Air Media disclosed that:

The interactive platform is built on our TV-attached digital frames and will integrate with our digital TV screens in airports in the future. By sending a text message or scanning a QR code through mobile devices, air passengers can attend lucky draws to win attractive prizes. Through the interactive platform, clients can continuously reach and engage air passengers not only at airports but elsewhere in their daily lives through mobile devices. We believe that this interactive platform will not only increase the media value of our products by attracting greater viewer attention, but also enable us to charge clients an effectiveness based performance fee in addition to the regular display fee.

First point: Within just 9 months of that bullish disclosure, Air Media announced that it was divesting the promising TV-attached digital frames business, describing it as unprofitable. At the same time, the company announced that it would be divesting itself of its airport digital TV screen business, again unprofitable.

Second point: These divested businesses were tiny in size. Air Media divested itself of 81% of the TV-attached digital frame business for just $1.1 million. The digital TV screen business accounted for just 5% of revenues in 2014.

The key point here is that these divestitures were so small that they are clearly not going to swing money-losing Air Media to a $31 million profit all the way from a $25 million net loss - even as other revenues are in sequential decline. Anyone can do the math here.

But again, I repeat: Anyone who believes that Air Media’s sub will earn $31 million in 2015 should certainly be buying the stock with both hands. Because that is the basis for pricing on Liantronics taking this supposed 5% stake.

The fact that investors do not believe this is borne out by the 12% drop in the share price following the PR.

Problem #3: What about the “put options”?

Another major reason why the stock fell after the press release was that this was the first time that many retail investors came to understand the “put options” embedded in the supposed “deal”.

In the original April 7th press release, Air Media failed to mention the fact that this “deal” could be cancelled for any reason whatsoever.

The company has described one of these options as a “call option” and the other as a “put option”. But both of these options amount to the same thing: the right to cancel the transaction. Each of Liantronics and Air Media therefore have the full right to simply cancel the deal. As a result, I continue to use the term “put option” for both of these clauses.

In its response PR, Air Media noted that:

… Liantronics requested and has obtained a put option to revoke the Transaction after the expiration of the Waiting Period.

The reason that the stock originally soared by 150% over several weeks was that the initial press release from Air Media indicated that the company had a “done deal” on 5% of the Air Media sub. That “done deal” fueled the speculation that Liantronics would buy the entire company for $500 million.

Yet, even the 5% “deal” can simply be cancelled for any reason (such as the $31 million profit target), or in fact, cancelled for no reason at all.

The 150% run-up in the stock was nothing more than a naïve retail tradebased on incomplete and misleading information that had been put out by Air Media.

Problem #4: Air Media will now exit the advertising business?!?! Huh?

In its initial press release, Air Media announced: “AirMedia Sells 5% Equity Interest of its Advertising Business for RMB150 million”. This was then repeated in the annual report that came out last week.

Shareholder approval for that proposed transaction was apparently not required, because the transaction was very small. But now, in its response to my article, Air Media has revealed that:

We intend to sell the remaining equity interests of our advertising business in the foreseeable future so that we can focus our resources on the exciting Wi-Fi business.

This statement alone clearly hit many investors as a thunderclap. This statement alone would have caused pressure on the stock.

The “advertising business” comprises 80-85% of the business of Air Media. The company is suddenly planning on exiting it entirely. This is the equivalent of Starbucks (NASDAQ:SBUX) saying that it will be exiting the coffee business to focus on selling pastries – but without ever having told its shareholders.

If true, this exit is a monumental shift in the company’s business, yet there was no disclosure of it in the annual report that just came out a few days ago, nor was there any hint of this on the recent conference call.

Again, this was a thunderclap.

For those who actually caught this statement in the press release, it is yet another reason why the stock fell 12% and closed at the lows of the day.

Yet, the fact that Air Media should want to exit the advertising business is entirely understandable. The business loses money every year. Revenues are declining. Guidance is for further declines. The company is dumping off once-promising businesses for almost no consideration. Nearly 50% of its existing concession will expire by the end of 2015, with aggregate concession costs of over $400 million. So again, the desire to get out of this business is completely understandable.

The point is that if it were a profitable business, Liantronics would genuinely be thrilled to buy it. If it is not profitable, then Liantronics will not. It is entirely as simple as that. That is the reason why Liantronics included a $31 million profit condition, as well as the right to simply cancel the transaction for any reason.

Problem #5: What about this new WiFi business?

Air Media now has said that it wants out of advertising, and for very obvious reasons. The business is faltering badly. But the new direction of the company into WiFi appears to be not much better. Air Media would prefer the uncertainty of the new venture over the certainty (which is bad) of the existing business.

To be sure, the WiFi business has some enticing headline numbers. Air Media has already told us that the Shanghai Bureau alone had 275 million passengers on high-speed rail in 2014, while ordinary trains had 175 million passengers.

It was already one year ago that Air Media won its first contract to provide WiFi on trains from Guangzhou Railway Corp . At that time, the company had told investors that:

We believe the huge traveler volumes by airplanes and high-speed trains, which can be easily monetized, have great commercial value.

But now it has been a year later. There have been multiple new WiFi concessions announced for Beijing, Shanghai, Xinjiang and several others.

Yet, we can see that none of these WiFi announcements has ever moved the stock. The question is: “Why?”

One reason is that a full year later, we have yet to see any meaningful revenues from this business. But more important is the business model itself.

In the recent conference call, Air Media stated that it would be giving away the WiFi service for FREE on trains, and then hoping to make up the losses by getting revenues from advertisers or e-commerce companies.

This may come as a shock to those few who have thought that Air Media would actually be charging for providing WiFi. So after a decade of being an advertising company, it will now be switching 100% of its business into giving away free WiFi. Again, this is a radical and unproven strategy for the company, which may take years to show any results, while requiring substantial upfront capital.

This is why such news has never buoyed the stock. And this disclosure is yet another reason for yesterday’s 12% decline.

Some background on the retail hot money

A few weeks ago, I wrote a scathing article about a small company with significant problems. Following my revelations about this company, the stock was down by more than 50% within a few days. As with Air Media, it was a stock held overwhelmingly by retail investors.

As with Air Media, that company quickly responded to my article with a strongly worded press release, and noted that: “The Company believes the statements made in yesterday’s Report are inaccurate and contain numerous errors of facts, speculation and interpretations of events”. Yet the stock fell further.

At this time, I quickly began seeing online commentary from small investors that it was time to “buy the dip and play the rebound”.

Much of this was inspired by the company’s promise to put out a further response and business update on the following Monday. With the stock down 50%, clearly there was more upside than downside, and there was a positive catalyst in the works. Or perhaps not.

When Monday rolled around, the announcement they got was that the chairman had been arrested over the weekend as he was attempting to flee the country, following my article and that the business prospects were actually quite mediocre.

That stock quickly plunged yet another 20%, and was then halted. It remains halted today. Prospects look grim. Sadly, I see retail investors stuck in this type of “fool’s trade” all too commonly.

Prior to the response from Air Media, the stock had been listed as one of the top 10 “hot stocks” on Chinese retail trading site xueqiu.com. Today, it fell off that list, and we can see from the comments that sentiment has turned suddenly negative. Retail sentiment on Twitter has also suddenly turned bearish. Likewise for retail sentiment on Yahoo Finance. The comments on Seeking Alpha are almost unanimously negative on Air Media.

The point is that retail hot money can easily move stocks up or down, particularly when they are relying on inaccurate or misleading information provided by the companies they follow. These investors often follow simple headlines and rumors, and are much slower to read the actual disclosure which will determine where the stock will ultimately trade. Some of these investors will no doubt eventually read the disclosure from Air Media and then add to the selling pressure. Other retail investors may simply tire of a “headline trade” that is now faltering. Either way, with the only hoped-for catalysts (a company response and a hoped-for “deal”) now out of the way, there is little to support the stock from further downside.


The misleading information coming out of Air Media over the past month saw the stock rise from $2.00 to $5.00 – a rise of 150%.

Air Media led investors to believe that it had a “deal” for 5% of its subsidiary, when in fact, there was no deal. Air Media failed to mention the fact that there was a $31 million profit target. The company then failed to mention that the deal could be canceled by either side. It has now led investors to believe that Liantronics has completed due diligence, when it has merely hired advisors to simply begin looking at the company.

And now the company says its “believes” that the sub responsible for 80-85% of its business will suddenly become profitable after 5 years of consistent large losses simply due to the divestiture of two negligible subsidiaries.

Despite this never-before-released positive guidance, Air Media has suddenly disclosed that it wants to exit the advertising business entirely, just to focus on giving away free WiFi. Until yesterday, it had never disclosed this bombshell to anyone.

The reasons for exiting the ad business are clear. The business has lost money for 5 years straight. Revenues continue to decline. Guidance is for further declines in revenue. Nearly 50% of the current concessions expire by year-end, with aggregate renewal costs of over $400 million. Business is very, very rough.

Yet, we are expected to believe that after Liantronics completes due diligence, it will want to buy the Air Media subsidiary for DOUBLE the current value of the entire company.

This simply defies common sense, and it fully explains why Liantronics required a profit target along with the right to cancel the deal.

The response PR made these problems much clearer to investors who previously had no idea.

As soon as the response PR came out, Air Media’s stock began to fall and closed down 12%, at the lows of the day.

The company is overwhelmingly held by retail investors. Some retail investors who have bid up the stock may be slow to figure out the nuances of the PR. But we can see from the stock price action that the new information in the PR has shown that others are clearly starting to “get it”.

We can see this from new sentiment on retail-focused sites such as Yahoo, xueqiu.com and Twitter, as well as on Seeking Alpha.

As that sentiment spreads to other fickle retail traders, Air Media could be set for much steeper declines in the next few days.

Additional disclosure: The author was previously an investment banker for a major global investment bank and was engaged in investment banking transactions with a wide range of Chinese companies. The author has not been engaged in any investment banking transactions during the past 5 years. The author is not a registered financial advisor and does not purport to provide investment advice regarding decisions to buy, sell or hold any security. The author currently holds a short interest in AMCN and over the past 12 months has provided fundamental and/or technical research to investors who hold a short position in the stock. The author may choose to transact in securities of one or more companies mentioned within this article within the next 72 hours. Before making any decision to buy, sell or hold any security mentioned in this article, investors should consult with their financial adviser. The author has relied upon publicly available information gathered from sources, which are believed to be reliable and has included links to various sources of information within this article. However, while the author believes these sources to be reliable, the author provides no guarantee either expressly or implied.

After Recent Spike, Straight Path Could Fall 50%


  • Straight Path holds wireless spectrum and patent troll assets. The stock is up by 100% in the past month and is held overwhelmingly by retail investors.
  • Announcements that it was suing Apple, Verizon and others sending the stock soaring. But past awards to STRP have been consistently at just $1-2 million from other giants.
  • Straight Path’s patents begin to expire next year, and two weeks ago (AFTER the Apple/Verizon announcement) elements of the first one were invalidated by the USPTO as “unpatentable”.
  • Straight Path’s wireless spectrum assets are in the millimeter bands and are years away from commercialization, if at all. There is currently no logical reason to bid up the stock.
  • Yet retail investors have bid up the stock by 100% due to a simple FCC blog post requesting comments on mm spectrum. Straight Path is likely to fall 50%.

The recent travails of Globalstar Inc (NYSEMKT:GSAT) serve well to illustrate how retail oriented stock promotions can achieve wildly overvalued share prices until they are found out and come crashing back to earth. Prior to a report from Kerrisdale Capital, Globalstar had been trading at almost $4.00. Following a lengthy exposé on the true value proposition at the company, Globalstar fell to as low as $1.56, a max decline of well over 50% within 2 weeks. It has now rebounded slightly. Institutional ownership stands very low at just 35% and there is minimal institutional research on the name. It is overwhelmingly a retail investor stock play which explains how the stock ended up trading up to such unjustifiable levels (and why the crash was so severe).

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The company I am focused on today is Straight Path Communications (NYSEMKT:STRP) whose share price is up by around 100% in the past month solely due to a handful of misunderstood headlines regarding its wireless spectrum and its small portfolio of patent troll assets. Once investors grasp the underlying reality, Straight Path is likely to give up most of these recent gains, and should fall by around 50%, back to where it was a few weeks ago. In April, Straight Path had traded as low as $6.00. It is currently trading at north of $20.00.

Straight Path currently has a market cap of $250 million. Despite the rise in the share price, there is virtually no short interest in the name, at just 2% of shares outstanding and only 1 day’s trading volume. As far as I can see, there are at least 1 million shares available to borrow at brokers such as IB.

Also like Globalstar , institutional investment is very, very low at just 26%. There is no institutional research coverage for Straight Path. Please note that Straight Path has a July 31 year end, such that it just released its annual report for Fiscal 2014 (which ended in July) and the company is now in fiscal 2015.

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In short, Straight Path soared because it announced in September that it was filing patent claims against Apple, Avaya, Cisco and Verizon. Retail investors are envisioning massive settlements with hundreds of millions, simply based on the size and scope of the giant targets.

But the reality is that Straight Path has already filed and/or won 12 similar suits against very similar defendants, including some of the largest giants in the tech space such as Blackberry, Netflix, Vonage, Sony, Toshiba, LG, Samsung, Skype, and Ebay. Despite the dozen wins, Straight Path has only brought in a total of $18 million, or around $1.5 million each.

In fact, the most recent 4 wins (against BlackBerry, Netflix, Vonage, and ZTE) only brought in an average of $600,000 each. At these levels, these suits can only be described as “nuisance suits”.

In addition, although announcing these wins for the full size, Straight Path has only recognized $4.4 million as revenue in 2014 because the remaining amounts are deemed too uncertain to be collected. Yet thesunk legal costs of these wins already exceeds $8 million. So far straight Path has only recognized $2 million of these costs.

But wait, it gets better. The patents that Straight Path is asserting actually start to expire in 2015 – just next year – making the ultimate future of this business very limited.

But wait, the best is yet to come.

On October 9th, (three weeks after the announcements of launching the Apple/ Verizon suits) the USPTO ruled that various parts of the Straight Path’s primary core patent (the ’704 patent), were “unpatentable”.

As a result, it may now be impossible to even collect on the suits that are in process.

No 8K was filed at the time announcing this development. Instead it was simply buried in the recent annual 10K filing.

A back and forth legal battle has begun over this patent, and Straight Path has noted its intention to appeal.

A second reason for the spike in the share price was an announcement from the FCC which simply stated that it was asking for comments in a Notice of Inquiry on the potential use of spectrum bands above 24 GHz for use in mobile communications. This could one day potentially include the spectrum assets (28GHz and 29 GHz) owned by Straight Path. But even the company itself discloses that any progress on this is likely to be years away, if ever.

In fact, the spectrum assets (which have been owned by Straight Path / IDT since 2001) are already being utilized by customers including AT&T, TelePacific Communications and UNSI.

So what are the bringing in for revenues ?

For all of 2014, total revenues from spectrum amounted to just $424,000 in 2014 and $525,000 in 2013. And (as shown below) that is the level we should probably expect for at least the next 5 years.

But again, as with Globalstar, a small group of retail investors has somehow come to the conclusion that they alone have figured out that Straight Path is sitting on a spectrum goldmine. As we will see below, this is demonstrably not the case.

Background of Straight Path and IDT Corp

Straight Path was spun out of its parent company IDT Corp (NYSE:IDT) in 2013. IDT is best known for its legacy as a provider of discount calling cards for making international calls. As competition from free or ultra cheap international calling services (such as Skype, Magic Jack and Vonage) has increased, this business has become nearly profitless and IDT reached out into a wide range of get-rich-quick schemes in a variety of areas including investment in shale oil, hedge funds, real estate, consumer debt collection, broadcasting and even comic books. This also includes Straight Path.

The spectrum assets which are now part of Straight Path were first acquired by IDT for $55 million in 2001 from bankrupt Winstar Communications. Winstar had spent hundreds of millions on that same spectrum before going bankrupt with it. IDT then spent hundreds of millions of dollars itself, trying to build out these assets. It then abandon these efforts before spinning off the assets to shareholders in the form of Straight Path.

IDT has largely been run as a family fiefdom for and by the relatives of CEO Howard Jonas. Mr. Jonas appointed his son Shmuel (aka “Samuel”) Jonas as the COO of IDT at the age of 25. Shmuel’s previous experience was as an apartment manager in the Bronx and as an operator of a frozen dessert delivery business. Mr. Jonas also appointed his other son Davidi (aka “David”) Jonas as CEO of Straight Path. Davidi’s former experience was that of a Rabbi in the Bronx and a high school teacher of Judaic studies. Davidi was 26 years old and has been employed by IDT / Spectrum since 2012. IDT’s General Counsel (responsible for approving its large corporate transactions and spin offs) happens to be Mr. Jonas’ sister, Joyce Mason. IDT obtained its insurance policies from IGM Insurance Brokerage, owned by Mr. Jonas’ father, his mother and his brother in law (Jonathon Mason). Mr. Jonas also appointed his son-in-law (Michael Stein) as Vice-President of Corporate development.

The point is that because of these relationships, it is easy to approve these get-rich-quick ventures which are notably value destructive and unfriendly to shareholders. As featured in Crain’s New York Businessthese diversions into high risk, speculative (and totally unrelated) ventures such as Straight Path have now cost IDT shareholders over $1 billion in destroyed value.

As noted by Crain’s, “IDT’s Howard Jonas has a million ideas. He’s lost $1 billion. Read about his latest scheme.”

Each time the new ventures fail to produce results, IDT typically spins them off to shareholders, as it did with its failed energy project, Genie Energy (NYSE:GNE). Genie is a shale oil play which was IDT acquired at the peak of the shale boom and then was later spun off to IDT investors in 2011. The share price of Genie has fallen from $9.00 in 2011 down to $7.00 at present, although (like Straight Path) it did see a brief spike in 2013 to almost $18.00 before falling by more than 50% to current levels.

As we saw with Genie, we are currently seeing a similar spike in Straight Path which should correct quickly back to its original level of $10.00 or so.

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The typical modus operandi for the IDT spinoffs is for the Jonas family to take additional management and board positions in the new company, paying themselves handsomely. At Genie, Howard Jonas (CEO of IDT) also became the new CEO and Chairman, paying himself handsomely for the role despite the fact that the share price has faltered and Genie continues to lose money.

At Straight Path, Mr. Jonas appointed his 26 year old son, Davidi Jonas, as CEO, and has already awarded him over $1 million in compensation. As mentioned before, Davidi had previously worked for his father at IDT for almost 2 years, but prior to that, his only work experience was as a high school teacher of Judaic studies and as a Rabbi. Again, that is the CEO of Straight Path.

Straight Path currently has only 6 employees and operates out of space in Glenn Allen, Virginia which it rents for just $575 per month. A separate office in New Jersey is rented for $733 per month.

What caused the share price of Straight Path to double ?

Back in early September, Straight path was trading at just $9-10 on very low volume. But a series of announcements from the company has sent the stock doubling since then, recently hitting an all time high of $22.00.

Straight Path has two business segments. One is in wireless spectrum assets and the other is in enforcing patents (ie. patent trolling) with a small portfolio of IP assets. The recent announcements pertained to both segments.

In each case, the announcements have been largely misinterpreted by the overwhelmingly retail investor base, such that the share price should be expected to return to around $9-10 when investors realize the facts.

PART I: The real prospects for the patent portfolio ?

The first catalyst for the spike in Straight Path was an announcementthat on September 24th the company had filed patent infringement complaints against Apple Computer (NASDAQ:AAPL), Avaya Inc. and Cisco Systems (NASDAQ:CSCO). On September 26th, the company then filed against Verizon Communications (NYSE:VZ).

Clearly this is something that could have multi billion dollar potential, right ? Wrong.

We can actually get very close to determining the value of these suits. Based on past facts, it is highly likely that Straight Path will in fact prevail in these suits. The company has already filed similar suits against other tech mega giants including: Sony, Toshiba, Blackberry, LG, Samsung, Skype, EBay and others. More importantly, it has already been winning these suits.

But the key point here is that while Straight Path has indeed won these infringement suits, the amounts that it has won have been tiny. They have also been very consistent in their size.

As I will show below, there are a wide variety of issues facing Straight Path and its patent troll prospects. What it all boils down to is that the revenue prospects are very much limited. Yet by bidding up the stock by 100%, retail investors are clearly assuming that there must be truly massive revenue potential ahead. This is wrong.

There is precisely zero chance of Straight Path winning even $10 million off of any one of these suits. In fact, the real number is most likely less than $1 million each.

Problem #1: The amounts won are demonstrably very small

For the year ended July 31, 2014, Straight Path won 8 of these suits against the tech mega giants, for a total of $15.8 million, which amounts to around $2 million each.

In the subsequent few months, Straight Path prevailed in 4 more suits, bringing in $2.4 million more. For this second part, we are now talking about just $600,000 each for the suits against the giants BlackBerry, Netflix, Vonage, and ZTE.

Again, it should be kept in mind that these tiny awards have been in suits against the largest giants in the tech industry which have combined revenues in the hundreds of billions. These are basically just “nuisance lawsuits” designed to pull in around $1 million dollars each and the giants can just pay to make them go away.

The point is that even if we can expect Straight Path to win in the suits against Apple, Avaya, Cisco and Verizon, the amounts will likely be in the range of $1-2 million each (at most). So at most we are talking about perhaps $6-8 million. At the low end of the range ($600,000 each) we would be talking about less than $3 million in total.

Clearly even in the best case scenario, this doesn’t merit the stock price doubling in a few weeks, adding over $100 million in market cap. Instead it was just excessive and misplaced retail enthusiasm due to the headlines about suing Apple and Verizon. There is no chance of a massive settlement for Straight Path.

Problem #2: Running out of new parties to sue

Relative to the other problems, this one is relatively minor. But it should become fairly obvious to readers.

So far Straight Path has filed suits against around 15 parties which includes the following:

- Skype

- Ebay

- Bandwith.com

- Blackberry

- Sony

- LG

- Sasmsung

- Toshiba

- Vocalocity

- Amtran

- Huawei


- Vonage

- Verizon

The problem now is that Straight Path will quickly run out of new parties of adequate size to sue. There are a limited number of giant targets in this size range and Straight Path has now hit most of the low hanging fruit. Only a few other names (such as perhaps Hewlett Packard) quickly come to mind. Straight Path will no doubt broaden its target list. But at most, the company might be able to find another 20 parties to sue. As the parties get smaller and smaller, the likely awards will also get smaller. So we can assume that future revenues from patent trolling may be somewhere in the range of perhaps $20-40 million at most, and perhaps even less than $10 million as the award sizes shrink. This would include any proceeds that we should expect from Apple and Verizon.

But as we will see below, looking at gross proceeds ignores the cost of litigation which can be in excess of 40%. It also ignores the fact that much of the awards are “contingent” and collection is not even reasonably assured. So in reality, the likely best case scenario is now a future benefit to Straight Path of less than $20 million.

Problem #3: what are the REAL revenues ? what are the COSTSassociated ?

Clearly the headline numbers look great. In a short period of time, Straight Path appears to have pulled in over $18 million in patent troll wins. But this is not the case. In fact, for the full year of FY 2014 (ended July 31), Straight Path only recognized $4 million in revenue from these suits. The total wins as of that time were already over $16 million. One problem is that portions of the amounts are too uncertain in terms of collectability to declare as revenue. It is not as simple as “win $16 million and collect $16 million”.

Meanwhile, the costs associated with these wins are very concrete and represent money already spent. These costs already exceed $8 million spent for just $4 million in recognized revenues. But Straight Path has so far only recognized $2 million of the costs.

As a result, the real benefit (in terms of profit) to Straight Path has so far been just around $2 million from all 12 suits.

Problem #4: Straight Path’s patents begin to expire in 2015(next year !)

Here we can see that the problems start to become more serious and structural.

Retail investors have gotten very excited about Straight Path’s patent troll prospects, but not just because of the recent wins. These wins (a total of $18 million in revenues, only $4 million of which was recognized) are clearly too small to justify a doubling of the share price and an extra $100 million in market cap.

Instead, these wins are being taken as an indicator that bigger and better wins are set to come and the Straight Path can truly make a sustainable business out of suing tech giants. Unfortunately, that party is set to end much quicker than many retail investors understand.

The reality is that the key patents begin to expire next year such that there is truly no sustainability to the patent troll revenue stream.

This is why Straight Path was in such a rush to begin filing suits as soon as the spin off was completed and why it continues to rush to hit the biggest names in the industry (such as Apple) as fast as it can.

Problem #5: As of October, elements of Straight Path’s core ’704 patent were found to be “unpatentable”. Is it game over ?

Back in April of 2013, Straight Path was already suing Sipnet EU, a Czech technology company, for infringing Straight Path’s core ’704 patent. Sipnet filed with the US patent office for a Inter Partes review with the goal of demonstrating the claims within the patent are in fact “unpatentable”. Straight Path fought this hard in 2013, but just two weeks ago, on October 9th, the USPTO issued an administrative decision that most of the ’704 patent is in fact “unpatentable”.

Despite the magnitude of this decision, Straight Path did not put out an 8K at the time to disclose it to investors. Instead, it was simply buried within the recently released 10K (page 15) that:

During the pendency of an inter partes review, or related appeal, any litigation related to the patents in review could potentially be subject to an order to stay the litigation while the review proceeds. Therefore, while a review is pending, we may be unable to enforce our patents.

This all happened after the announcements about suing Apple and Verizon sent the stock soaring. Yet it may now be the case that Straight Path cannot even attempt to enforce ANY of the pending suits.

As shown in the final decision from the USPTO:

The Board has jurisdiction under 35 U.S.C. § 6(c). This final written decision is issued pursuant to 35 U.S.C. § 318(a) and 37 C.F.R. § 42.73. For the reasons discussed below, we determine that Petitioner has shown by a preponderance of the evidence that claims 1-7 and 32-42 of the ʼ704 patent are unpatentable.

Yesterday an 8K was filed noting that the action had been stayed (as expected from the disclosure above), and that Straight Path has again said it intends to appeal.

The point of all of these problems is that investors have massively overestimated that revenue potential from Straight Path’s very limited patent portfolio. In doing so, they have bid up the stock price by as much as 100%, adding $100 million in market cap. The fact is that the realized benefit to Straight Path has only been a few million dollars.

Future benefits are certain to be very limited due to the expiring patents and the fact that elements of the core ’704 patent have now been found to be “unpatentable”.

PART II: What about with wireless spectrum ?

The fantasy of winning riches from the wireless spectrum game is now turning into a classic value trap for retail investors. We saw it with the rise (and then plunge) in Globalstar and we are now seeing it again with Straight Path.

This is not much different that what we saw with the boom and bust in marijuana stocks earlier this year, and what we have seen with Ebola stocks in recent weeks.

As with Globalstar, Straight Path is overwhelmingly held by retail investors and lacks any meaningful institutional analyst coverage. In both cases, retail investors should ask themselves why both buy side and sell side institutions are shunning these companies as investment ideas. After all, if there were even modest prospects for large upside, institutions would be flocking to these stocks in droves. But they are not.

Prior to the spinoff of Straight Path, parent company IDT had acquired the spectrum assets from Winstar out of bankruptcy in 2001. IDT had paid $55 million for these assets. Winstar had spent hundreds of millions of these assets and went bankrupt in the process.

The logic of this particular scheme was that paying $55 million for something that had recently been “worth” several hundred million must be a good deal. The problem was that just because these assets had “cost” several hundred million, didn’t mean that they were “worth” anything at all.

IDT then spent as much as $300 million trying to effect its own build out on these assets. But when this failed, the company simply spun off Straight Path as a separate entity to IDT shareholders. This is the same model that IDT has used for multiple other failed business ventures, including Genie Energy.

So far, the spectrum assets have proven to be of limited use. Total revenues from spectrum for the past 2 years have amounted to just $424,000 and $525,000.

But the hope is that the FCC will one day approve the very specific frequencies held by Straight Path for use in mobile communication networks. At that time, the value of these spectrum holdings would soar dramatically.

The FCC recently put out a Notice of Inquiry, which I would strongly encourage people to read.

What it comes down to is this:

The FCC is now simply asking for comments about the implications of opening up the higher frequencies (above 24 GHz, known as the “millimeter frequencies”) for use in mobile communications in order to facilitate the eventual development of higher capacity “5G” digital networks. The bull case is that one day, this could potentially include the 28 GHz and 39 GHz frequencies where Straight Path has licenses.

The first point should be obvious. This is simply a “notice of inquiry” where the FCC is seeking a wide range of comments on technical and practical implications of opening the millimeter frequencies. The FCC is simply asking questions, not by any means delivering policy. As can be seen from the link above, the length and scope of the questions mean that this is a multi year discovery process.

The document runs 38 pages long and concludes with:

The beauty of today’s Notice of Inquiry is that no one in this room knows where it will eventually take us. Which spectrum bands above 24 GHz can be effectively used in the short term, over the long term ? Will the technologies be mobile or fixed, unlicensed or licensed ? What equipment will be necessary to utilize these bands ? Only research and time will tell.

Investors in Straight Path should pay particular attention to the reference to the use of unlicensed spectrum which would end up making the millimeter bands held by Straight Path largely worthless.

In fact, it is quite clear that the FCC is evaluating a broad range of alternatives for freeing up spectrum, most of which would have no benefit to Straight Path.

The second point is that there are a number of potential choices above 24 GHz. For Straight Path, it is clear that they are banking on the 39 GHz far more than the 28 GHz (LMDS). The company discloses that:

In the previous two quarters we have worked with a radio vendor that has developed a next-generation PMP radio that operates in the LMDS (A1) frequency. We have already entered into Spectrum leases as a result, and we expect the adoption of PMP to increase due to the cost effectiveness and flexibility to scale due to wide coverage area sectors.

We expect to work with this and/or other radio vendors to develop a similar offering in the 39 GHz frequency, where our Spectrum holdings are far greater. The development of such a radio will take time, and in the interim we are using our LMDS holdings to demonstrate the proof of concept with the intent of offering a similar capability in 39 GHz when it is available.

Keep in mind that the “Spectrum leases” which are referred to above are what was responsible for less than $1 million in revenues in the past two years combined.

The third point is that the advent of 5G networks is expected to happen by around the year 2020 or later. This is a widespread industry forecast as can be found by simply running a Google search on “5G 2020″. In other words, we are still 6 years away from even the potential for the widespread use of ANY millimeter spectrum in 5G networks. And again, there is certainly no guarantee that it will be the 39 GHz that Straight Path made its bet on 13 years ago. Yet the stock has already doubled in just a few weeks and now sports a market cap of over $250 million.

The objective of using millimeter spectrum is to build out backhaul networks for cell phone voice and data connectivity. The envisioned solution is that small antennae would be placed close to ground level in high traffic areas to connect those areas to the fiber optic network of the carrier. The key limitation is that these millimeter frequencies typically cannot penetrate intermediate objects such that they must be used in areas which are limited to “line of sight”. However, there are currently efforts being made to attempt to mitigate this limitation. These are all part of the issues that the FCC is reviewing to determine spectrum policy for 5G by 2020.


Shares of Straight Path have doubled in the past month simply due to extreme hype by the retail investor base over several press releases and 8K’s in late September. The news has been interpreted by the retail investors to mean that Straight Path is on the verge of winning mega patent troll suits against such giants as Apple and Verizon. The hype has also been driven by a simple blog post from the FCC requesting comments on the potential use of millimeter frequencies for cell phone backhaul networks.

The reality is that Straight Path has already demonstrated the full commercial potential of its patent troll portfolio. Its wins from tech giants such as Blackberry have recently fallen to an average of just $600,000 per suit, and that it without taking the 40% cost of litigation into account. In addition, the patents begin to expire next year, greatly limiting the potential for future suits. Most importantly, the USPTO has already begun invalidating parts of Straight Path’s core ’704 patent as being “unpatentable”. As a result, Straight Path may now be unable to enforce even the pending suits.

In wireless spectrum, Straight Path owns licenses in two bands, the LDMS and the 39GHz bands. The FCC has only just to evaluate the use of any millimeter frequencies and is now only requesting comment in advance of expected 5G rollouts in 2020. There are a wide range of alternatives for building backhaul networks, including the use of unlicensed spectrum. However, a blog post by the FCC asking for comments on the use of millimeter frequencies has also been the reason for the quick doubling of the share price in just a few weeks. The lengthy regulatory process and key limitations of the millimeter frequencies mean that any revenue potential from these licenses could be 5-6 years away. In the meantime, these assets generate just a few hundred thousand dollars per year.

The “news” which has caused Straight Path to double was hardly news at all. The doubling was more the result of retail hype and a lack of institutional ownership and lack of research coverage.

We have seen similar irrational price surges and crashes in other retail heavy names which can trade up solely on misplaced hype and sentiment.

As a result, the share price should be expected to return back to $10.00 from where it began just a few weeks ago.

Disclosure: The author is short STRP, GSAT. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The author was previously an investment banker for a major global investment bank and was engaged in investment banking transactions with a variety of technology companies. The author has not been engaged in any investment banking transactions with US listed companies during the past 5 years. The author is not a registered financial advisor and does not purport to provide investment advice regarding decisions to buy, sell or hold any security. The author currently holds a short interest in GSAT and STRP and has provided fundamental and/or technical research to investors who hold a short position. The author may choose to transact in securities of one or more companies mentioned within this article within the next 72 hours. Before making any decision to buy, sell or hold any security mentioned in this article, investors should consult with their financial adviser. The author has relied upon publicly available information gathered from sources, which are believed to be reliable and has included links to various sources of information within this article. However, while the author believes these sources to be reliable, the author provides no guarantee either expressly or implied.

Aemetis (AMTX): Solvency Concerns And An Upcoming Equity Offering


  • Aemetis now has over $90 million in short term debts coming due but only $4.7 million in cash. The company has already begun defaulting on its short term debts.
  • This short term nature is not reflected in the recent 10Q due to an accounting technicality that has been missed. More serious accounting issues may have also been missed.
  • Creditors have already assumed as collateral ALL of Aemetis’ assets and are now sweeping cash from Aemetis every night. Creditors are attempting to seize assets.
  • Aemetis recently filed a $100 million S3 and retained an investment bank to advise on financing. A massive near term equity offering is the only option for Aemetis.
  • With share price falling and no other options, the stock could enter a “death spiral” and decline by 50-80%. Past fraud charges for CEO could exacerbate equity discount.

Investment overview

Aemetis Inc (NASDAQ:AMTX) is a company which is totally off the radar for most investors. The company only recently uplisted to the NASDAQ from the OTC BB and has no institutional following. As a result, the mostly retail investor base has missed some critical issues with the company.

Between May and July, shares of Aemetis rose from $5.00 to over $12.00. But now the shares have been dropping daily. Even though earnings on August 7th were relatively positive, the shares have fallen by 20% since then and are already down by more than 30% in just three weeks.

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The reason that the positive earnings did not cheer the stock is because Aemetis is very deeply in debt and is already defaulting on obligations in both the US and India. Creditors have already taken 100% of the cash generated by Aemetis this year and are first in line to take anything else that Aemetis can make. Creditors are already attempting to seize assets.

It is clear that Aemetis must issue a massive amount of new stock to pay creditors and it must do so quickly. Aemetis has over $90 million in short term debt coming due and only $4.7 million in cash.

Aemetis has already filed an S3 registration statement to raise up to $100 million and has engaged an investment bank to help with financing. The equity offering will put extreme pressure on the share price. This is what is driving the share price down.

Because Aemetis MUST complete a financing regardless of price and because of the urgency, the share price will continue to fall sharply. No one wants to be the last one holding shares when the company conducts a huge equity offering.

The shares could fall by a further 50-80% due to the “death spiral” nature of this financing situation. Past examples will illustrate this problem clearly and why it applies to Aemetis.

Again, the reason that the market has missed this is simply because:

a) Aemetis is an under followed stock

b) Aemetis is mostly held by retail and has no legitimate research coverage

c) Aemetis only recently uplisted to the NASDAQ from the OTC BB


In 2013, I wrote an article describing a “death spiral” at Biolase Inc. (NASDAQ:BIOL) which saw the stock plunge by 80% in a week. The situation was very similar to what we are starting to see now with Aemetis.

In early 2013, the Biolase share price was quite strong and traded as high as $6.00. In August 2013, Biolase had just reported earnings and reported a very mild miss. It certainly should not have been a big deal. But still, the share price plunged by 25% that day. The death spiral had already begun….however, many investors had not yet realized it.

By the time I could finish my article within a few days, the stock had already fallen by 50%. Despite this massive drop in less than a week, I still predicted even further declines. The stock then fell an additional 30% on the day of my article alone.

With the stock down 80% in a week, Biolase took the unusual step of halting their own stock when it hit $1.16, down from $3.60 before earnings. It was an epic plunge in just days, and a far cry from $6.00 just weeks earlier.

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Biolase was ultimately able to stabilize and raise some of the money it needed. The stock has recovered to around $2.00, still down by 45% from where it was before.

Biolase offers a good lesson in what triggers a death spiral. Biolase was in violation of its loan covenants and needed to raise money urgently. Issuing stock was the only option and investors could plainly see that Biolase had filed a large S3 registration statement to sell stock. The situation with Aemetis is nearly identical, except that Aemetis has far more debt that Biolase.

In general, a death spiral will occur when a company needs to pay a fixedobligation (ie. debt) and when it must use a variable number of shares to do so. Investors know that the stock will fall upon the equity offering, so they sell and the share price falls. But then the subsequent investors know that the equity offering has not yet happened, so they know that the stock will continue to fall further. They sell, the stock falls, and the cycle repeats again.

No one wants to get caught holding the stock because it is pre-determined that it will continue falling by even more. As the share price gets lower and lower, the relative dilution becomes larger and larger, which then exacerbates the share price decline even more.

As with Biolase, Aemetis Inc is now facing a death spiral situation, and for very similar reasons. And as with Biolase, it is purely the fault of management for letting the situation get to this point. More prudent management in years past could have prevented this situation from arising.

Aemetis: Company Overview

Aemetis Inc is a $200 million market cap producer of “alternative fuels”. The company produces biodiesel from a plant in India and produces mainly ethanol from a plant in California.

During Q1 of 2013, its ethanol plants were idled as the company was experiencing recurring negative gross margins. It was literally selling its product below cost, so it decided to shut down. In recent quarters, the company has resumed operations and a buoyant market for ethanol has seen the company begin to eek out tiny profits in two consecutive quarters. But it is still the case that over the past few years the company has accumulatedover $80 million in cumulative losses.

Aemetis Inc uplisted from the OTC BB to the NASDAQ in May and its share price quickly shot up from an initial price of $5.00 to over $12.00. One contributing factor was the strong performance of any stock with an ethanol connection. For example, Pacific Ethanol (NASDAQ:PEIX) is up by 400% in the past year. Aemetis has simply ridden on the coattails of the sector.

The share price was also no doubt buoyed by a Seeking Alpha article entitled: Aemetis Is A Potential Four- Or Five-Bagger as well as by the initiation of “research” on the company by See Thru Equity which came with a $26 share price target.

See Thru claims (in all caps) that it does not get compensated to write such reports. But instead, See Thru charges its clients $11,000 for slots at its conferences. It then issues hyper bullish research on the attendees “for free”. As noted on the See Thru website, Aemetis is an attendee in See Thru’s conferences.

In reality, this is all just a very transparent way to pay for positive research on one’s own company.

Both the article and the research report contain materials which are largely a simple repetition of company presentations, including links and direct quotes. As a result, they not surprisingly portray the company in a very optimistic light and contain multi-bagger share price targets.

Yet both of them ignore the obvious realities which are contained in the Aemetis’ SEC filings. Even a quick and cursory read of the company filings reveals the following:

- Aemetis already is and has been in default on its debts, with creditors already attempting to seize assets.

- The company has just $4.7 million in cash and over $95 million in short term debt coming due.

- Over $65 million of this debt has been classified as “long term” simply because it is due 1 day after the end of the quarter. As a result, that $65 million is all in fact short term debt by now.

- Aemetis’ major lender is already “sweeping” cash from the company every day, not even trusting the company with cash overnight

- The company’s internal controls for accounting have been deemed to be ineffective.

- Creditors have already claimed as collateral ALL of the assets of Aemetis

- In order to avoid an immediate default, the CEO was forced to personallyguarantee $15 million of the debts with 100% of his own personal assets. If Aemetis defaults on even this portion, he loses everything he owns – personally !

As a result of the above, Aemetis (and the CEO) are in the situation where they simply MUST issue stock at any price and in very large size. They must also do so as soon as possible.

The intention to issue equity should be clear. The company just filed an S3 registration statement for up to $100 million. It is huge for a company of this size. The company also disclosed that it has already “engaged an investment bank” to advise on its financing.

An equity offering is desperately needed, there are no alternatives and the timing is imminent. These are the precursors for a death spiral to occur. This is why the stock has been selling off even after earnings which were relatively good (compared to the past). Yet many of the retail holders will have no idea what is coming.

The only reason why the equity offering hasn’t already occurred is that the S3 is not yet effective. This is also identical to what happened with Biolase. But just as with Biolase, the S3 can become effective immediately and with no notice, such that an equity offering could occur at any time.

How has the market missed this ?

The reason why this obvious situation has been missed by the market is that aside from existing insiders, the stock is almost exclusively held by retail investors. There is no institutional presence in terms of either investors or research. Because the stock was just recently uplisted to the NASDAQ, it is largely unknown to the wider market.

Furthermore, there are many retail investors who simply invest based on company descriptions who happen to be in hot sectors (ie. ethanol).

The share price of Aemetis has no doubt benefited from the other soaring ethanol stocks such as Pacific Ethanol which has been a stunning 5 bagger in the past year. Aemetis CEO Eric McAfee was an original founder of Pacific Ethanol, so some people choose to associate the two together even though Pacific happens to be a far healthier company.

(click to enlarge)

How did Aemetis get into this situation ?

In 2012, Aemetis sought to acquire a company called Cilion, but it didn’t have the money. As a solution, Aemetis went to a predatory distressed lender by the name of Third Eye Capital. This was really the beginning of the end for Aemetis.

In July 2012, Third Eye lent around $40 million to Aemetis by means of loans, notes and a revolving credit facility. The “stated” interest rates have been as high as 17% but due to a creative variety of fees, the real rate of interest has approached 100% per year.

Aemetis clearly had no ability to repay these debts. In fact, it could not ever even service the interest alone. Within less than 6 months, the company was already in default.

As a result, in October of 2012, Aemetis and Third Eye entered into Waiver and Amendment #1. This extended the maturity of the obligations to July 2014 and increased the lending amounts by $6 million.

But…the $6 million could not actually be drawn upon by Aemetis, it was simply extended to account for the unpaid interest. For Aemetis, the only real result was that their debt increased to $46 million, instead of $40 million, with no new cash coming in the door.

Aemetis was just borrowing more money from Third Eye so that it could pay the money directly back to Third Eye. This is how Third Eye makes a fortune. In mafia movies, it’s called “the vig”.

But wait it gets better.

In order to compensate Third Eye for this extension and waiver, Aemetis was required to “pay” an additional “waiver fee” of $4 million. But again, Aemetis had no cash, so this was just tacked on to the debt. So now the obligation became $50 million, instead of $40 million. And again, there was not even any new cash coming in the door at Aemetis.

The balance of the debt therefore increased by 25% in just 4 months !

That equates to an annualized rate of over 95% !

That was October, 2012. Within just 4 more months (February 2013), the company was again in default. So Aemetis agreed to Waiver and Amendment #2.

This time, Aemetis was required to issue shares to pay an additional extension fee of $1.5 million. In addition, Third Eye required McAfee Capital to pledge millions of shares as collateral. McAfee Capital is the investment company owned by Aemetis’ CEO Eric McAfee and which holds some of his shares.

That was the second default waiver within 8 months.

The third default and waiver happened just 3 more months later, with more waiver fees and increased debt balances in respect of unpaid interest.

Then there was a forth default and waiver. And a fifth. And a sixth. And a seventh.

At each new waiver just a few months apart, Third Eye would impose additional fees and would jack up the interest rates. The net result was that by late 2013 (less than 18 months), Aemetis’ debt to Third Eye had ballooned to over $72 million from just $40 million.

The “vig” was quickly compounding at a truly unsustainable rate.

By the end of 2013 (within 18 months) total annual debt service amounts were accruing and almost $30 million per year – and this for a debt that started at just $40 million in its entirety.

But Third Eye still wasn’t satisfied and was repeatedly demanding warrants. Aemetis was already in default. If Aemetis attempted to say no, Third Eye could just foreclose on the assets of the entire company. Third Eye could now call all of the shots.

As a result of the heavy warrants and shares being issued, Third Eye quickly owned over 17% of the entire company !

But at the current valuation, Third Eye’s equity stake is worth just $34 million – only half of what it has lent to Aemetis. And the problem now is that Aemetis has demonstrated a very limited capacity to pay down these debts.

As a result, Third Eye is now agitating for the equity offering. In one default waiver amendment, Aemetis agreed to give Third Eye 100% of the proceeds of any equity offering it conducts in excess of $7 million. This is how Third Eye plans to get its money back.

The stock will clearly be crushed and Aemetis will end up getting almost none of the proceeds, but Third Eye will get its incredible pound of flesh out of the deal after just 2 years.

What happened with earnings ? Why is the stock falling ?

Last Thursday, Aemetis reported Q2 earnings and the numbers appeared good on the surface. But the share price quickly fell by 10% that day and continued its descent on Friday. This is just what we saw with Biolase.

In the press release, the company noted the following:

- revenues increased 21% vs. Q2 2013

- Net income was $2.7 million compared to a loss of $9 .6 million in Q2 2013

- Aemetis paid down $13.6 million of debt (interest and principal)

These all would appear to be very positive developments. As such, retail investors were likely confused by the sharp drop in the stock.

More savvy investors quickly realized that positive comparisons to 2013 are unfair because the plant had been idled for almost a month during Q2 2013. Had it not been idled, revenues would have come out as being largely flat despite a very buoyant ethanol market in 2014.

In reality, the results are actually a bit of a disappointment.

As for the debt, a closer read of the subsequently released 10Q reveals that debt service expenses are still accruing at over $5 million per quarter (a run rate of over $20 million per year). In addition, every penny of cash generated by Aemetis has already been handed over to creditors, mostly to Third Eye.

But even after handing every penny of cash that came in the door, Aemetis still has over $95 million in short term liabilities coming due. Aemetis has made virtually no progress whatsoever even in the best ethanol market in a decade.

Note: Many investors could have easily missed the short term nature of $65 million these liabilities because in the form10Q they are classified as “long term liabilities”. The reason for this classification is that Aemetis agreed with Third Eye to set the new maturity date as July 1, one day after Q2 ends. As a result, they were technically considered to be “long term” obligations in the most recent 10Q – but only by a single day. These obligations are now clearly short term liabilities.

For those who care about accounting ratios, Aemetis has a stated “current ratio” of 0.4. That should already be extremely concerning. Anything below 1.0 indicates meaningful financial weakness. Anything below 0.5 indicates a severe liquidity issue.

But in fact it is much worse. Because all of these liabilities are now short term, the real current ratio for Aemetis is just 0.1. The company is visibly insolvent.

What about “alternative” financing sources ?

California Energy Commission Grant

In late July, Aemetis put out a press release stating that “Aemetis announces $3M CEC grant award”. Even though $3 million is not enough to move the needle vs. over $90 million in upcoming debts, the $3 million would serve as a small amount of welcome relief.

However it appears that investors may have assumed that this money was already distributed to Aemetis. This is wrong.

There are several problems here. First, the grant is still contingent upon approval of the project. It has not even been distributed. Second, the grant is a matching grant which means that Aemetis itself must put up $3 million in order to receive the grant. But Aemetis only has $4.7 million in cash total. Third (and most importantly), as part of one of the default waivers, Aemetis already agreed that any proceeds from grants would go straight to Third Eye. Aemetis will see none of the money from this grant.

California Ethanol Producer Incentive Program.

Aemetis is eligible to participate in this California program which subsidizes ethanol producers in times when crush spreads are too low to make money.

Unfortunately, the program also requires ethanol producers to re-pay the funds when times improve. Because times are good for ethanol right now, Aemetis actually owes money to this program.

As a result of this, Aemetis noted in the most recent 10Q that:

During the six months ended June 30, 2014, the strength of the crush spread resulted in the accrual and obligation to repay CEPIP funding in the amount of $1.8 million, the entire remaining amount of funds received from the program.

This is in addition to the other debts listed for Aemetis.

EB-5 Visa program

This is an odd one. In an attempt to obtain funding, Aemetis enrolled in a program by which it can effectively sell US immigration visas to foreigners. Foreigners can “invest” $500,000 each into notes issued by Aemetis. Because they are investing in a US business and presumably creating jobs, the foreigner then gets a US immigration visa.

The notes can be converted into Aemetis stock at a price of $3.00 – but only after 3 years.

Even though this appears to be a great deal (getting stock at $3.00) Aemetis has only managed to sell 3 of these visa investments since 2012, raising just $1.5 million. The reason that there has been no demand is that investors need to wait for 3 years in order to get their stock. These investors will know that they come behind over $90 million in debt, such that there is a very real chance that they may never get paid. In fact, in 2013, Aemetis was not even paying the owed interest to these investors who paid their $500,000 each. Not surprisingly, selling more of these has been difficult.

Despite only selling 3 of these in the past 2 ½ years, Aemetis continues to state that this is a source of funding which they hope to rely upon.

But once again (and of greatest importance), Third Eye has already laid claim to any potential proceeds from this source. In Default Waiver #5, Third Eye forced Aemetis to agree to remit any proceeds from EB-5 sales to Third Eye.

Loans from board members

In the recent past, CEO Eric McAfee has already forgone actual cash payment of his salary and benefits because Aemetis is unable to pay. Aemetis simply accrues these expenses along with the other debts which it is not paying. But because 100% of his personal assets have been claimed by Third Eye as collateral, Mr. McAfee is no longer able to extend any form of credit to Aemetis.

As early as 2009, board member Laird Cagan extended $5 million of credit to Aemetis which was secured by assets of the company. But as per usual, the company was unable to even pay the interest. As a result, the company issued stock to Mr. Cagan in exchange for the $5 million debt. As a result of this, Mr. Cagan ended up quickly owning 12% of the entire company which he acquired at just 45 cents per share.

This once again demonstrates what we are about to see: when the company has debts which it cannot pay, and when issuing stock is the only option, the price at which stock can be issued tends to be very, very low. Aemetis will truly issue stock at any price because it has no other options.

Complications for an equity offering – accounting issues

I was an investment banker on Wall Street for nearly a decade. I helped many troubled companies raise money when the situation looked very desperate. One thing I learned is that there is almost always a price at which a deal can get done.

I do believe that Aemetis will be able to complete some amount of financing to stave off insolvency. But it is also clear that the price at which a deal gets done for Aemetis will be very, very low.

We already know that nearly all proceeds of the offering will simply be handed to Third Eye. This is already a problem for potential investors because they know that a financing will not go to improve the business or increases capacity. The financing itself does nothing for Aemetis and everything for Third Eye.

But in fact there is a much larger problem looming for Aemetis.

Aemetis may have additional accounting problems which could require an even bigger discount from anyone who might choose to finance the company.

In its annual 10K filing filed in March, Aemetis noted that:

We have identified material weaknesses in our internal control over financial reporting which have materially adversely affected our ability to timely and accurately report our results of operations and financial condition. These material weaknesses have not been fully remediated as of the filing date of this report.

The deficiencies in internal control were not minor, in fact they were very significant.

The 10K (p. 28) explained that there may be significant problems with the numbers, most importantly including cash flow numbers.

The material weaknesses identified are: Ineffective controls exist to ensure that the accounting and reporting for complex accounting transactions are recorded in accordance with GAAP. A number of significant audit adjustments were made to the general ledger, which collectively could have a material effect on the financial statements. These adjustments were made up of entries to properly record the carrying value of debt issue costs, warrant accounting and various other adjustments summarized in our Report to the Audit Committee communication.

As part of our review of the financial statements included in the 10-K, we also made significant revisions to the statement of cash flows and various notes to the financial statements, which indicate that additional controls over disclosures need to be evaluated.

The company also noted that it was making efforts to remediate these problems.

But here is where it becomes much more problematic.

A few weeks later when Q1 was reported, Aemetis noted that

There were no changes in our internal controls over financial reporting during our most recently completed fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Despite the “no changes”, Aemetis management is now saying that the previously disclosed problems no longer matter.

On page 30 of the 1Q 10Q and on page 35 of the 2Q 10Q, it is noted that:

Our controls and procedures are designed to provide reasonable assurance that our control system’s objective will be met and our CEO and CFO have concluded that our disclosure controls and procedures are effective at the reasonable assurance level.

Something is quite wrong here.

When a company discloses serious deficiencies in its accounting controls in one quarter and then says that no changes have been made, it is not possible to suddenly say that the numbers, including cash flow, are all just fine. Yet this is what Aemetis has done.

The fact that these problems are being swept under the rug at just the time that the company is looking to complete a large equity offering makes the problem that much worse.

This is clearly something that small retail investors will miss, but larger investors who might finance the company will spot immediately. To the extent that they have any concerns over the accuracy of the accounting numbers, they will definitely require a steeper discount on the equity price.

Past 10b5 fraud charges against the CEO, Eric McAfee, will not help that matter either.

In a previous OTC BB oil and gas company, Verdisys, Mr. McAfee was also the largest shareholder and CEO.

According to the SEC, McAfee duped the company’s board into buying useless software from a different company which he controlled. He then diverted that money to a stock promoter to promote the stock.

McAfee then fabricated a large receivable from a supposed customer and forced the accounting department to put out the 10Q filing without letting the auditor review it. The auditor had already raised revenue recognition issues with the transaction. He did all of this in order to prevent the share price from falling.

This is all pretty bad stuff. As a result, Mr. McAfee was sanctioned for fraud violations and cease and desist orders were issued.

Here is what happened according to fraud proceedings with the SEC:

Verdisys issued two million shares of common stock, valued at $1 million, ostensibly to acquire software, but that the software had been deemed not useful, and Verdisys was therefore recording an impairment expense of $1 million.

McAfee had convinced the Verdisys board to purchase the software by claiming it would allow the remote monitoring of oil and gas wells, which would complement Verdisys’ sales of broadband satellite links to oil and gas companies. McAfee controlled the company selling the software, and he knew that the software only screened job applications and resumes of health care executives and did not monitor conditions in oil and gas wells. McAfee did not tell the company’s directors that the transaction compensated a stock promoter, who received half of the two million shares.

As a result, McAfee caused Verdisys, essentially a start-up company, to not disclose that it had issued one million shares and incurred a compensation expense of $500,000, to retain the promoter, before it could claim significant assets, revenues or business operations.

Verdisys delayed the filing of its quarterly report for the quarter ended September 30, 2003 (the “3Q Form 10-QSB”), after its auditor raised revenue recognition issues concerning a material $1.5 million receivable related to the company’s largest drilling contract. While the filing was in abeyance, McAfee caused Verdisys to issue an earnings release predicting the company would soon report record earnings.

McAfee participated in efforts to justify recognition of the $1.5 million receivable. On November 19, 2003, to meet the filing deadline and avoid any drop in the company’s stock price, McAfee ordered Verdisys’ accounting staff to file the 3Q Form 10-QSB, even though the auditor had yet to review the financial statements found in the filing. The 3Q Form 10-QSB filed as a result claimed Verdisys had earned total current period revenues of $2.09 million, including the questioned $1.5 million receivable. The 3Q Form 10-QSB did not disclose that McAfee’s attempts to confirm recognition of the $1.5 million receivable involved a buy-out agreement, by which Verdisys would assume substantial liabilities and forego collecting upon the $1.5 million receivable to purchase the drilling project from which the receivable arose.

As a result of the conduct described above, McAfee caused Verdisys to violate Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, which prohibit fraudulent conduct in connection with the purchase or sale of securities.

Ultimately McAfee settled with the SEC, paid a fine and moved on to other projects. Verdisys later changed its name to Blast Energy and is no longer listed.

I don’t expect that any retail investors have conducted this level of research in evaluating their investment in Aemetis. But it should be expected that investors who might choose to participate in an offering of up to $100 million will focus quite clearly on this history.

The fact that Aemetis recently disclosed its internal accounting problems and then quickly covered them up just in time for a financing will certainly be noticed and will be another factor which will require a steep discount in selling new equity.

It will not be lost on the investors that absolutely all of Mr. McAfee’s personal assets have been pledged to secure the loans of Aemetis. If the Aemetis creditors choose to foreclose, they will take everything he has. As a result, there is a very high amount of pressure on Mr. McAfee to get an equity deal done and to perhaps conveniently overlook the accounting problems which might interfere with getting his personal assets back under his own control and out of the clutches of Third Eye.

Please note: I did attempt to contact Aemetis by phone for comment and clarification on these issues but my calls have not yet been returned.


Right now there are very strong tailwinds boosting alt energy stocks such as biodiesel and ethanol plays. This can be clearly seen by looking at the soaring share prices of stocks such as Pacific Ethanol.

But unfortunately the dire straits in which Aemetis has landed basically ensure that no amount of tailwind is going to benefit Aemetis shareholders. For any amount of cash that comes in, Third Eye Capital stands ready to confiscate it. Third Eye is already “sweeping” cash from Aemetis every night. That applies to cash from biodiesel and ethanol sales, from grants and subsidies and even from Aemetis’ unusual US visa selling program. Third Eye and the lenders take everything.

Aemetis has over $90 million in near term debts and just $4.7 million in cash with which to repay it. But as of the last 10Q, much of this was technically referred to as “long term” debt. There is no mistake that this is currently short term debt now.

Aemetis has already defaulted on loans and its creditors have already begun attempting to accelerate the seizure of assets. Each time a default is waived for a few months only adds massive new debt burdens to the company in the form of waiver fees, penalties and new interest. The “vig” is compounding at an unsustainable rate.

But now the burden is getting so high that Aemetis risks collapse and now Third Eye finally needs to convert these debts into cash.

Aemetis has filed a $100 million S3 in order to sell equity and has engaged an investment banker to advise on financing. As a result, the share price has already fallen quickly by 30% in 3 weeks.

But now that the financing becomes more visible, the share price decline is likely to accelerate. No one wants to be left holding the stock when all of the other buyers disappear ahead of the offering. This is just what we saw with Biolase last year when the stock plunged by 80% in a single week.

Concerns over accounting issues and internal controls will likely mean that the discount required in an equity offering is even deeper than might otherwise be the case. Investors will want to know why Aemetis is now ignoring the accounting problems just revealed in March, and why they are being ignored right ahead of a must-complete equity offering. The past history of similar fraud by the CEO will certainly not help this issue with investors.

Based on these issues, a quick drop of 50-80% in the share price is now entirely predictable.

Disclosure: The author is short AMTX. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The author was previously an investment banker for a major global investment bank and was engaged in investment banking transactions with variety of alternative energy companies. The author has not been engaged in any investment banking transactions with US listed companies during the past 5 years. The author is not a registered financial advisor and does not purport to provide investment advice regarding decisions to buy, sell or hold any security. The author currently holds a short interest in AMTX and has provided fundamental and/or technical research to investors who hold a short position. The author may choose to transact in securities of one or more companies mentioned within this article within the next 72 hours. Before making any decision to buy, sell or hold any security mentioned in this article, investors should consult with their financial adviser. The author has relied upon publicly available information gathered from sources, which are believed to be reliable and has included links to various sources of information within this article. However, while the author believes these sources to be reliable, the author provides no guarantee either expressly or implied.

Behind the promotion of Northwest Bio (NWBO)


  • Northwest Bio has been the subject of a massive promotional campaign which has seen the stock price soar.
  • Many of the authors involved have close hidden ties to promotional firm MDM Worldwide and / or Redfish Creative.
  • In some cases, authors have used fictitious identities and fake credentials within healthcare or finance. In fact they are simply paid writers.
  • Redfish Creative reveals its use of bulk pricing for writing undisclosed promo articles and mass message board postings on Yahoo.
  • Much of the promotional information written on Northwest has been either misleading or downright wrong.

Note: As part of his investigation, the author has shared the contents of this article along with additional materials with the United States Securities and Exchange Commission.

Note: Additional links and information on these topics has been and will continue to be shared via the author’s website. Readers can sign up for email alerts at www.moxreports.com. All content provided is always free of charge.


Since 2013, shares of Northwest Biotherapeutics (NWBO) have more than doubled. At their peak, they were a triple from last year.

During this time, Northwest has raised nearly $80 million from equity issuance on the back of the strong share price.

The driving force behind the share price has been a string of promotional articles from a variety of authors which have issued very bullish predictions for the stock.

In most cases, the technique being used by these authors is to write on Northwest in conjunction with press releases being released by the company.

Northwest has minimal institutional interest from outside investors at just 29%. As a result, the stock is easily influenced by analysis that is sophisticated in appearance.

As I will show below, many of the authors who have written on Northwest are using fake identities and fake credentials. They pretend to be biologists, other scientists or fund managers. In fact, they are just paid writers.

Since mid 2012, Northwest has made use of an IR and “social media” stock promotion firm called MDM Worldwide. Shortly after Northwest began paying MDM, the bullish articles began to appear from these fake authors. At the exact same point in time, MDM built a website for Smith on Stocks and Larry Smith quickly initiated coverage on all of MDM’s small cap biotech clients (including Northwest) with bullish / buy views. Smith has since written heavily on Northwest and has been the most ardent and outspoken bull on the stock.

These authors on Northwest have a broad and visible connection MDM and / or to “content” firm Redfish Creative, which has done work for MDM. Redfish has already provided me with pricing sheets outlining how much it charges for different types of (undisclosed) paid articles. Redfish has also laid out its techniques for (undisclosed) paid writing on message boards.

Both MDM and Redfish have emphasized the technique of writing articles in conjunction with press releases being issued by their clients.

Mr. Smith has provided coverage to every single small cap biotech client that pays MDM. But both Smith and MDM have taken steps to conceal the relationship and have removed key disclosures.

Readers should note that after I contacted MDM for questions, they quickly notified Smith of my interest. Mr. Smith then found it appropriate to update some of his disclosures regarding his real bio which had been concealed from investors. This includes the fact that he was barred from the securities industry by FINRA among other issues.

As shown below, much of the content that has been written by the writers described has been either misleading or downright wrong.

Note: MDM has assured me that it has never paid anyone to write any article on any stock. Please keep that in mind as you evaluate the facts below. Mr. Smith did not respond to an email from me.


During the course of 2014, I have been highly focused on exposing undisclosed stock promotions which have artificially boosted the prices of various (mainly biotech) companies. My previous articles can be found here and here.

Public companies hired IR firms, who then hired writers (aka “consultants”) to conduct massive undisclosed promotions on a wide variety of media portals including Forbes.com, TheStreet.com, Seeking Alpha, Motley Fool and others. The consultant authors pretend that their analysis is independent from the company, but in fact their analysis is basically sponsored by the company and is (of course) heavily biased towards bullish conclusions.

Where this becomes illegal is due to Section 17b of the securities code which states that promotions must be disclosed if there is anydirect or indirect compensation from the issuer, from a broker dealer or from an underwriter. It was very clear in some cases that the issuers were involved in the promotion.

Section 17b reads as follows:

It shall be unlawful for any person, by the use of any means or instruments of transportation or communication in interstate commerce or by the use of the mails, to publish, give publicity to, or circulate any notice, circular, advertisement, newspaper, article, letter, investment service, or communication which, though not purporting to offer a security for sale, describes such security for a consideration received or to be received,directly or indirectlyfrom an issuer, underwriter, or dealer, without fully disclosing the receipt, whether past or prospective, of such consideration and the amount thereof.” (15 U.S.C. § 77q(B).)

The most notable example was the Dream Team Group, which was responsible for hundreds of articles in various sites that were entirely fabricated but which boosted the stocks of their biotech clients by hundreds of percent.

In some cases the authors have been “consultants” who are presumably not actually paid to write articles, but instead are ostensibly providing some other vague services during the time that they write the articles. The reality is that they only get paid as long as they write positive articles.

Single individuals have often used multiple aliases pretending to be industry experts. In many cases, these authors pretend to have strong credentials in the fields of medicine or finance when in fact they are nothing more than hired freelance writers who get paid by the article. Their bio’s are entirely fabricated.

As I will demonstrate below, it has now become apparent that these writers also infiltrate message boards such as Yahoo Finance and Investors Hub to create the false appearance of broad support from retail investors and to refute critics. But once again, these postings are simply bought and paid for and provide misleading information to unsuspecting retail investors.

The stocks involved in these promotions have been mostly biotechs and have tended to be overwhelmingly held by retail investors who can be easily influenced by the appearance of sophisticated and professional analysis. As their share prices soared, these companies raised tens of millions (each) via equity offerings which would have otherwise not been possible.

In the wake of my recent exposés, hundreds of promotional articles have been removed from these various sites. Some of the companies involved have already begun receiving subpoenas from the SEC. Many of the share prices have fallen by at least 40-60% from their promotional peaks.

Unfortunately some small retail investors still don’t understand the implications of being caught up in a stock promotion. Many retail investors take the attitude that:

I don’t care if there is a promotion going on. I believe that the results with the company’s drug will drive the share price. I have done substantial due diligence.

Unfortunately this view is very common when a stock is held overwhelmingly by retail investors.

But at a minimum, most investors will quickly realize that their “due diligence” has been largely based on information that is either highly biased to the positive or even outright wrong. It is information which has come largely from false experts who have undisclosed relationships and fabricated bio’s.

SECTION I: The Redfish world of paid stock promotion

So let’s get right to the point. Here is the pricing sheet which shows how much I would need to pay to get a stock promoted on various sites such as Seeking Alpha, Motley Fool, Yahoo or Investors Hub (see logos at bottom of graphic). The articles are written by professional writers and are structured to make intelligent use of SEO (Search Engine Optimization) technology in order to get maximum impact.

They are not your average bull articles, instead they are scientifically engineered to get the best response from readers. The authors being paid do not disclose any payment in their articles or any connection to MDM or other IR firms.

The techniques being used are far more sophisticated than those used by the Dream Team Group.

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This pricing sheet was provided to me directly from Redfish Creative. I did not use my real name when dealing with Redfish, for obvious reasons.

Redfish Creative is a small two man shop run out of Pittsburgh.

The “pricing” from the table above makes it clear that a “basic article” includes mere “factual research only”. I can have one of those for a mere $250. But because it is only factual it therefore has “low readership value”. So let’s forget about sticking to the facts.

By contrast, the more expensive “intelligent content” article will “help the reader form an opinion” or will “reinforce company branding”. This is of key importance. The value of these articles is to persuade investors to buy the stock – not to merely convey facts. This will only cost me $500, which seems like a bargain (but keep in mind, that is very much in line with rates I was quoted by Dream Team authors earlier this year. It is the standard rate for various firms in the “phony article” business.)

But if I want an interview of management published, it will cost me $1,000. Some readers may remember that in my past articles on stock promotion I was highly suspicious of what I referred to as “gratuitous interviews” being posted as articles on certain stocks. Now you can clearly see why. The interviews are nothing more than paid infomercials being conducted by paid writers who ask convenient questions to management in exchange for $1,000. Such interviews are then published on main stream sites under the guise of being independent. They have proved highly effective.

So those are the pricing options.

As I will show below, a small group of Redfish related authors have now written dozens of articles on Northwest Bio, and have written more than 100 articles on other MDM clients.

I did make it a point to contact Mr. Eastman. And I made it a point to inquire about how he promotes stocks in exchange for money. Eastman has emphasized that their process typically involves the use of management when writing on companies and they try to make use of interviews wherever possible.

Note: In the week before this article, I did contact Northwest Bio with questions via email. I received no response.

Here is what Eastman had to say via email. The full text of the email can be found posted here at MoxReports.com.

Thanks for the inquiry. We do indeed work in this environment and have multiple years of experience in doing so. We generally start with a content strategy and subsequent content plan for the target company and work closely with principles involved establishing objectives-outcome, media outlets etc. At times weconduct interviews of key management personnel as part of the content plan as this proves beneficial for the richness of the content itself, along with upcoming catalysts, events, industry news etc. We have a team of writers who publish on multiple sites including Seekingalpha.com, Motley fool, etc. We also control several outlets as well that can be used for advantage.

As for pricing, Mr. Eastman goes on to note that:

Our content plans range from $1,000 monthly to $3,500 monthly depending upon selected items, features, etc. I think you will find them to be very effective. If we are covering multiple firms, we can adjust a pricing plan accordingly.

In a separate email to me (full email available here atmoxreports.com), Mr. Eastman goes on to clarify that Redfish “employs” 4-5 writers (“contractors”). He would not name MDM specifically as his client due to client confidentiality within his contract, but he did go on to give some unmistakable hints about who he was working for:

A good indication though is that if you look at the subject companies we written about (ticker symbol) we were likely retained to by someone with an interest in those firms. It is never the company itself, but rather an IR firm, individual investor, or group of investors.

We have also worked over a 3-4 year period of time with aInvestor Relations-Social Media form in NYC. They represent about 20 firms. We built their entire social media structure and content plans.

Even better, Mr. Eastman included links (shown in the email link above) to 5 sample articles (including on Northwest) for which Redfish had been paid. 4 of these articles were clearly on MDM clients. In addition, Redfish states it was involved in creating MDM’s “Chairman’s blog” website.

But in short, there should be zero doubt that Mr. Eastman is referring to MDM as his client. But this should become more clear when we look at the articles that various writers have written on MDM clients below.

(Note: MDM did confirm with me by phone that it has used Redfish in the past, but stated that it has never paid anyone to write any articles on any companies.)

SECTION II: Promotions – which companies and how much promotion ?

We will now start to see a variety of companies which have been promoted. The reason I am focused on Northwest is that it appears to be the most heavily and broadly promoted and because the stock has been such a strong performer as a result of the promotion.

The following table lists MDM clients and the authors who wrote about them most heavily. MDM used to list its clients on its webpage. But following my March articles on undisclosed stock promotions, MDM deleted the client page. It can still be found using an internet tool called the Wayback Machine for those who care to verify MDM’s client list.

The numbers in the table represent the number of articles written on each MDM client by each author.

We can see that Northwest Bio (an MDM client since 2012) ranks #1 with more than 3 dozen articles. Almost half of these have come from Larry Smith (Smith on Stocks). Smith will be discussed in greater detail below.

All of the authors below (including Smith) have ties to MDM. This will also be clarified below.

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The key point from the table above is that this small group of affiliated authors doesn’t just write on one or two MDM clients by chance. Instead, they each provide extensive coverage to a large number of MDM clients even when those companies are in totally different industries, are of totally different sizes and have no sensible overlap. In the bottom row, we can see the total number of articles that each author has written on MDM clients.

Together they have written 169 times on MDM clients ! (See bottom right of table)

This is true even for the nano cap penny stocks such as 9 cent Amarantus (AMBS) and even the 1 cent PLC Systems (OTCQB:PLCSF).

This is also true even when it requires writing on other tiny illiquid nano caps (all of which are MDM clients) such as Chanticleer (HOTR) and Mobivity Holdings (MFON). Chanticleer runs a string of Hooters restaurants and has very little in common with Mobivity, a mobile marketing company.

Both of these MDM clients are just $15-20 million in market cap and largely illiquid. They have attracted minimal attention from anyone other than Redfish writers. Yet the authors who write about these two totally unrelated stocks tend to a) write about both of them (not just one of them) and b) write heavily about biotech companies who have also paid MDM.

Please note: I didn’t find these patterns by accident. Mr. Eastman did inform me of a substantial and effective paid campaign that was run on MDM’s Chanticleer / Hooters.

After Mr. Eastman told me about Chanticleer, finding the rest of their articles became easy. In many cases, the authors named above are about the only authors who have expressed interest in these companies. At the time, truly independent authors had no virtually interest at all in many of these tiny, illiquid nano caps.

The patterns described here should be quite obvious from looking at the table above. If they are not immediately obvious then you should have another look at the table and it should become quite clear.

It should also be clear that these various “Hooters authors” have written most heavily on Northwest Bio with almost 2 dozen articles. The articles are mostly highly bullish and often served to buttress Northwest against the serious concerns of critics. (Those issues on Northwest will be addressed separately below).

SECTION III: The use of multiple fabricated bio’s and fake names

I have circled 5 fake identities at the top of the table above. In total, these fake authors alone wrote more than 60 articles on MDM clients, 66 articles on Northwest Bio alone.

Yet unsuspecting readers end up being duped into thinking that they are reading independent analysis coming from a real person with real credentials (such as a “fund manager” or a “biologist”) rather than a mere infomercial.

Anyone who is willing to do the work can find that these identities are fake. In fact, I believe that much of the writing behind them is being subcontracted out to Eastern Europe and the Philippines (where the level of English is high) using a placement firm called oDesk which is used by freelance writers and computer programmers.

For example, we can see that Louis Dematteis claims to be a “biologist” on Seeking Alpha and he has a closely cropped picture of his face. On linked in we can see the exact same (uncropped) picture for a man in Serbia named “Pavle Borovac” who contracts for oDesk. He is a mere contract web designer for hire, not a “biologist” who invests in biotech. Here is his profile as a web designer on oDesk. Nearly all of the Louis Dematteis articles can be directly tied to MDM clients, including Northwest.

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I strongly encourage readers to click the links above to see that the pictures are in fact identical, just cropped differently.

But let’s keep looking at more of the people who have been writing on Northwest Bio and other MDM clients.

I strongly encourage readers to click on the links to the named authors below to read their bio’s. It would actually be amusing if it weren’t so illegal.

Alberto Savrieno is a supposed “European” who works for a “family office”. Yet he has written on 12 articles on MDM clients. Again, oddly this includes the $15 million company Hooters, it also includes tiny Mobivity along with 3 articles on Northwest.

Likewise for Andreas Spiro from “Geneva” who wrote 19 articles for MDM clients. Again, this includes $15 million market cap Hooters and $20 million Mobivity. He wrote 3 articles on Northwest.

The list goes on an on, and includes “Richard Richter“, “Suresh Gupta” from India and “Louis DeMatteis” the biologist.

Note: Please make en effort to remember these names, as they will become more important in the text below.

The identities described above are all to some extent fabricated or enhanced and are being sponsored by one underlying party with a strong interest in MDM’s clients. In total they have written nearly 2 dozen articles on Northwest Bio alone as part of more than 60 articles on MDM clients.

I did not include the writer Austrolib in the list of fake authors. This author who states he “invests in the Austrian economic tradition” (another European reference) can be found to be living in Miami, where he “writes financial content for a living”. So he is simply using a psuedonym and is not truly fake. He has written 12 articles for MDM clients, 4 articles on Northwest.

In the past, these authors were not discreet about the team effort, as shown in the following screen shot showing related articles for Car Charging Group (CCGI). They all write on the same companies at the same time.

This can be also seen clearly on their Hooters (Chanticleer) campaign where almost every article comes from one of these named authors. Again, Chanticleer is an MDM client and Mr. Eastman informed me that he had conducted a paid campaign on Chanticleer for an IR firm in New York.

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When describing the need for such promotions, Mr. Eastman pointed out to me that:

Please remember the company itself cannot generate their own content as it is PR, and there are SEC and FDA rules to content with. That leaves paid individuals as I’ve mentioned above, and journalists and the like, to do a good job. It is long term.

SECTION IV: What about Larry Smith (Smith on Stocks) ?

Observant readers will also note the presence of Larry Smith of Smith on Stocks in the table above.

Smith is important because he has been the most ardent bull on Northwest (and because he has provided dedicated coverage to all of MDM’s other small cap biotech clients as well). His articles have repeatedly moved stock prices of Northwest and other MDM clients.

Yet Mr. Smith has been concealing many important issues from his readers and from investors.

This includes his close relationship and history with MDM, the real details behind his professional background as well as his investor relations activities.

Last week I called MDM and asked a few questions about MDM’s relationship with Smith and with Eastman. As already mentioned, MDM has clearly informed me that there is no paid promotion campaign with any MDM clients.

Shortly after that call to MDM, there began to appear posts on Yahoo message boards stating that Richard Pearson would be writing a negative article on Northwest Bio.

At the exact same time, Mr. Smith suddenly provided an extensive update to his existing disclosure on Seeking Alpha and on his web site. He clearly knew that the jig was up and he began revealing details of his past which had previously been concealed.

It is quite clear from this chain of events that MDM was on the phone with Smith as soon as I hung up the phone.

I would encourage readers to read the new disclosure by Smith and ask why this very damaging information is only coming after he was found out by me. After explaining his “ethical breaches” and the “scarlet Letter” on his name resulting from his regulatory expulsion from Wall Street, Smith has now made it explicitly clear in his disclosure that he does not receive any compensation from IR firms or from hedge funds. He only receives subscription revenues from his site.

In a few paragraphs, I will highlight some hidden disclosures by Smith which describe the business of his DLS Research.

But let’s start from the top and see why Mr. Smith had to put out this new disclosure after he learned about my investigation.

First, Smith was kicked out of the brokerage and research business in 2003 when he was barred from the industry by FINRA. Smith notes in his (newly updated) disclosure that the mediator had specifically sought to end Smith’s career on Wall Street due to the violations involved.

Prior to being expelled, Smith had spent his last 8 years in the business bouncing around between small no-name shops (ie. not as a big hitter at H&Q or Smith Barney as shown in his various profiles).

Prior to a few days ago, Smith had only disclosed to readers his early career history at two prestigious firms, H&Q and Smith Barney. He neglects to show how he ended his career by working for his last 8 years at various no name bucket shops such as Sutro and Rodman & Renshaw. None of this had been disclosed to readers or investors until the last few days when Smith was alerted by MDM that I was paying attention to it.

Below is the real history from FINRA broker check.

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Mr. Smith has actively touted his incredibly strong bio in various locations and as extra ammo within his articles. He has made it clear that his experience and expertise are the reasons that we should listen to him and not to the uninformed critics of Northwest.

The incredibly strong bio that he has portrayed in his profiles has helped him move the stock of Northwest and others.

The key point is that Mr. Smith has clearly cherry picked a certain portion of his career to portray to investors while ignoring the parts that indicate bucket shops. As we will see below, this type of deliberate cherry picking is exactly what he does when presenting information on Northwest Bio. It is a technique.

Smith then neglected to mention to readers that the reason he left the industry in 2003 was that he had actually been barred altogether from the industry by FINRA.

According to FINRA Broker Check:

Smith engaged in conduct inconsistent by effecting stock transaction shortly before issuance of research report which he had prepared concerning such stock; caused a violation of exchange rule 472.40(2)(III) by failing to disclose that he held securities in stocks recommended in research report he authored; engaged in conduct inconsistent by opening accounts at a member firm that concealed fact of his employment at another member firm; and violated exchange rule 407(b) by maintaining securities at another firm without consent of his employer.

The seriousness of these offenses for a Wall Street analyst cannot be overstated. Smith showed a deliberate willingness to deceive his employer, the brokerages and (most importantly) investors.

As a result, in 2003, Smith was barred from the industry for the time. This is what really resulted in Smith launching his “consulting firm” DLS research.

As we will see below, DLS Research (ie. Larry Smith) was created to focus on investor relations and stock promotion and not “research”. DLS does not have a website, nor does it even publish research reports.

As we will also see below, DLS (ie. Larry Smith) has also advised institutional investors on financing deals for biotech clients and then he takes additional compensation when warrants are exercised. Smith on Stocks continues to write positive articles about those companies.

Concealing a close relationship with MDM

Ultimately Smith launched SmithOnStocks.com which does write about stocks. MDM did confirm with me that they built the site for Smith. Smith posts ample content on his site and then condensed content on Seeking Alpha which then links to his site.

Since establishing a relationship with MDM, we can see that the majority of his articles fall into two categories: either a) companies where he has advised hedge funds and where he has received compensation tied to their warrants or b) companies who happen to be clients of MDM.

For a time we could see the connection between Larry Smith (Smith on Stocks) and MDM in several places online. But immediately after my March articles on illegal stock promotion, both Smith and MDM took deliberate steps to conceal their relationship.

Below is a page from MDM’s website prior to March. The Smith on Stocks logo is featured prominently, along with a list of other MDM clients.

This page was deleted from the MDM website in March, shortly after my previous articles exposing illegal stock promotions. It can be found by using an internet tool called the Wayback Machine.

I added the red squares to highlight the stocks which Smith has written about. Clearly, there are plenty of MDM clients in which Smith has no interest, right ? Look again.

Smith only writes about biotechs, and he doesn’t write about nano-cap penny stocks. A few of the MDM clients listed are not even public. So if we white out the non-public companies and the non-biotechs, and then gray out the nano cap penny stocks, we can see the following:

Voila !

What we can see is that Smith has written on precisely every single “small cap biotech” stock which is an MDM client – bar none. More importantly, he has done so quite often (more than 60 times on Seeking Alpha alone plus dozens more on his own site). Smith is clearly a genuine asset to MDM.

Next we should look at the timing.

Smith originally developed his own website, which was run by Blueline International up until mid 2012. This can again be found using the Wayback Machine. It is notable that up until that time he had never written about any MDM client, despite having written over 100 articles on a wide variety of biotech companies.

In early 2012, MDM built a new website for Smith and he quickly began initiating MDM clients with “buy” recommendations.

This includes Smith on Stocks favorites such as Neuralstem (CUR), Insite Vision (INSV), OncoSec (ONCS), Trius Therapeutics (TSRX) and Agenus (AGEN), and of course Northwest Bio , among others. It quickly included 100% of MDM’s “small cap biotech” clients.

Again, this of course excludes MDM clients which are not public, which are not biotechs or which trade for just pennies.

Now, do you remember Louis Dematteis (the fake “biologist”), Andreas Spiro, Richard Richter, Alberto Savrieno, Suresh Gupta and the other fake “Hooters authors” from above ? These were the authors that can be tied to Redfish and writing on MDM clients. Ryan’s View was also a key writer.

How did the timing of Smith’s initiations coincide with these other authors ? Look and see.

Shortly prior to Smith’s initiation of Northwest Bio, most of these authors did not even exist and had never written on anything. But as soon as Smith began initiating on MDM’s clients, the variety of fake authors suddenly appeared and began initiating on the same exact stocks…at the same exact time….with the exact same bullish views.

This can be best illustrated by looking at MDM client Northwest Bio. Smith initiated on July 26th, 2012 stating “I am starting my coverage of Northwest Biotherapeutics with a Buy.”

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Not convinced ? The same can be seen with MDM client Insite Vision and the other MDM clients covered by Smith. In each case, these authors did not exist shortly before Smith initiated coverage. As soon as Smith initiated on the name, the newly created fake authors from above initiated at the same time. Not surprisingly the views were all the same as well telling investors to by the stock.

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Still not convinced yet ? How about MDM client Nova Bay (NBY) ?

For those who need even more convincing, I strongly suggest going back and looking up the first articles being writing on each of the MDM clients listed in the table in Section II. You will see the same pattern repeated again and again for MDM clients where Smith is involved.

More deliberate steps to conceal the relationship

Starting just at the time of these group initiations in 2012, it was suddenly noted on Smith’s site that his site was “powered by MDM Worldwide”. This can also be verified with the Wayback machine.

But following my articles on paid stock promotions (published in March 2014), this reference was deleted from his web page. As with the deletions by MDM, this effectively concealed the relationship. The changes to Smith’s website occurred at almost the exact same time as the page deletions on MDM’s site shown above.

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What does “DLS Research” really do ?

Fortunately I managed to find an old version of his web page which included an unpublished description of what DLS Research really does. Again, this was a version with no external links to it buried inside Smith’s site. I believe Smith does not know it is still findable. I put a red box around the DLS text which is not being disclosed to readers. But as we can see from the language, this text was writtenafter the launch on Smith on Stocks.

SmithOnStocks is owned by DLS Research, LLC, a biotechnology consulting firm that was founded in 2003. DLS Research, LLCdoes consulting work of various forms primarily with biotechnology companies and biotechnology investors. In no event does DLS Research seek to obtain access to or use non-public material. This consulting work can include but is not limited to advice on competitive forces; addressable markets; how to make disclosures to investors; opinions on investment strategies of potential investors; current financing trends on Wall Street and how they may affect the company; how to attract potential interest in the company from Wall Street analysts and Internet bloggersgeneral investor relations advice; reproduction in audio, video and written form of previously presented management event presentations and press; helping the company’s various releases to gain broader viewing throughout the Internetidentifying investor websites that are interested in companies like theirs, etc. Consulting fees start at nominal rates and can increase based on the amount of work that is done. In most cases, the consulting will be done with companies that the author knows very well, believes have interesting potential and on which SOS may write. No consulting client companies have editorial rights of any kind in regard to any publications of SOS and each recognizes and acknowledges that SOS will endeavor to only write a balanced view representing both negative and positive investment aspects of any company.

I was also able to uncover a separate hidden page which describes further activities of DLS Research and how it interacts with institutional investors. This page can be found if you type in the exact right address, but there is no link to it from Smith’s main page. Unless you figure out where to look, this page also cannot be found. Mr. Smith may have simply forgotten about it.

It reads as follows:

DLS Research has performed due diligence for an institutional investor that was instrumental in its decision to invest in equities of certain companies. As part of that investment theinstitutional investor received warrants. DLS Research, LLC has no ownership in any of these warrants, but may receive cash compensation if the warrants obtained are exercised; this is a component of the consulting fee received for the due diligence. This type of agreement applies to the following companies: Acadia Pharmaceuticals, Access Pharmaceuticals,Athersys, BioSante Pharmaceuticals, Corcept Therapeutics, Cyclacel Pharmaceuticals, Discovery LaboratoriesMela Sciences, Oxigene, Soligenix and XOMA.

The odd thing here is that Smith gets paid only if the company ends up raising new money when the warrants are exercised. Again, this relationship has remained undisclosed on his website and on Seeking Alpha. It helps to explain his views on non-MDM clients such as Athersys (ATHX), Discovery Labs (DSCO) and Mela Sciences (MELA).

Smith most recently published strong findings on Discovery Labs on June 13th, 2014 stating: “I continue to recommend purchase of Discovery Laboratories.”

No free lunch from Smith on Stocks

SmithOnStocks.com is a “subscription” web site which Mr. Smith runs and where he puts up substantially more content than he does on Seeking Alpha. Mr. Smith charges $29.99 per month to subscribe to this site.

Despite the subscription charge, much of the detailed content is 100% free to readers.

Yet “free” is apparently a relative term.

By analyzing the articles on his site, we can see that the majority of content for MDM clients (such as Northwest) and for his warrant clients (such as Discovery Labs and Athersys) is disseminated forfree, maximizing the distribution.

The point of all of this is that Smith only initiated coverage on Northwest after he initiated a relationship with MDM. Since that time he has become a prolific writer on Northwest and suddenly on all of MDM’s other small cap biotech clients. The timing coincides perfectly with the creation of new (fake) authors who focus almost exclusively on MDM clients and who can be tied to Redfish.

Smith has taken deliberate steps to conceal his regulatory background, his IR activities and his relationship with MDM. Yet Smith has also been the loudest and most vocal defender of Northwest Bio against critics who see the company as being promotional and misleading investors. During this time he has been a very vocal and prolific writer on Northwest.

SECTION V: Beyond articles – looking to the message boards

Getting back to Eastman and Redfish again, we can see that these types of promotional efforts are highly professional. They are not limited to simple bull articles. Instead, content is highly engineered to be optimized for search engines. Mr. Eastman has made this very clear to me.

In addition, the effort extends to engaging in conversations on message boards to gain further traction and the appearance of widespread popular support.

For Northwest Bio, this is highly relevant because the stock has a very active message board with hundreds of posts per day. Sadly, many retail investors rely on the NWBO board as a source of information and can be swayed by the sheer volume of positive comments that come out.

Below is a copy of the brochure the Redfish sent me which deals with message boards.

Anyone who has relied upon their “friends” from the Yahoo or iHub message boards may now wish to strongly rethink their confidence in the bullish analysis being found on these sites.

A favorite tactic for the paid shills is to try to generate camaraderie amongst retail investors to resist “the shorts” or “the bashers”. In fact, many of these warnings are coming from people using false identities who are being paid for their efforts.

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Message boards are dumb. Hopefully most readers here are aware of that. But they also have a tremendous impact on retail investors. This is why stock promoters make heavy use of message boards.

Note: As mentioned before, early last week I did contact MDM with questions for this article. Shortly thereafter there began to appear messages on Yahoo Finance warning readers that I would be publishing an article on Northwest Bio and why readers should not listen to me.

SECTION VI: How sophisticated have targeted articles become ?

Mr. Eastman emphasized to me the importance of scientifically engineering the articles to achieve the desired effect. Simply writing a “dumb” article touting a stock has become entirely ineffective these days. More is needed.

Separately, several years ago MDM had released a case study on one of its clients where it noted:

MDM first monitored keywords, investor boards for sentiment, studied traffic patterns, and discovered other hidden points on the world wide web where discussions were taking place that were directly focused on ACT as a company, as well as the discovery of opportunities for discussion based specific technology and research interest segments. Success in this campaign was made possible through careful consideration traffic flow and direction to and from websites where analytics could usefully be tracked. This was accomplished throughcreation of new ‘discussion based’ content centered andbased on press releases, implementation of discussion based topics to accompany the new content, deep linking those ‘discussion based topics’ to company controlled articles(within specific groups and social media accounts) based on the saturation of interest, and then monitoring traffic to and from those entry points.

That case study has since been removed from MDM’s website. But the point is clear: engineered content is far more sophisticated than most readers understand and it requires coordination with company issued press releases.

SECTION VII: Northwest Bio – evaluating discrepancies vs. disclosure

Northwest has paid promotion firm MDM Worldwide to manage a “content strategy” and/or media strategy. MDM has special relationships with authors who then write positive articles on its clients. That much is quite obvious. It is what MDM does.

During this time Northwest has continually issued various statements to investors in the form of press releases and SEC filings. These press releases have served as necessary fuel for MDM, Eastman and Smith.

As for MDM, even the company’s own website has emphasized the importance of coordinating press releases and “news” with “discussion based content” and “company controlled articles”.

As for Mr. Eastman’s, we can evaluate his previous comment again:

Please remember the company itself cannot generate their own content as it is PR, and there are SEC and FDA rules to content with. That leaves paid individuals as I’ve mentioned above, and journalists and the like, to do a good job. It is long term.

As for Mr. Smith, there was the hidden disclosure from his DLS research that notes that his work includes:

helping the company’s various releases to gain broader viewing throughout the Internet

The point of this is that without a steady stream of press releases, it is almost impossible for promoters to generate fresh content. Northwest has issued steady streams of press releases which are then picked up and turned into “discussion based content” by the real and fake authors we have seen above.

In many cases, investors are substantially persuaded to buy the stock, but without the author every telling any outright lies. The author is seldom foolish enough to write that 2+2=5. Such a strategy would be downright foolish and would be immediately disproved by other authors.

Instead, the authors often include large caveats about content being just an opinion or being uncertain. But in the end, investors are told to rely upon the credentials and credibility of the author. As we can see with Smith, the portion of his bio which he chooses to reveal was indeed impressive and in the past has helped him generate support from thousands of followers.

The examples that follow are not in any way meant to be exhaustive. These are just a few of the relevant examples.

IMPORTANT POINT: The point of these examples is NOT whether or not the reader agrees with the author on the facts presented. The point is whether or not the author has made statements which contradict Northwest’s formal disclosure in any way.

Note: In the week prior to publication of this article, I did attempt via email to reach both Larry Smith as well as Adam Feuerstein. Neither party responded with comments.

Example #1 – The “giant needle” debate ?

Just prior to ASCO, Northwest made public some data that indicated “extensive necrosis and partial collapse” of a tumor following just 3 treatments with DCVax-Direct. This seemed to “prove” that DCVax was working. The share price soared (as expected) due to the perceived effectiveness of the drug.

Adam Feuerstein of TheStreet.com remarked (sarcastically)

I’m shocked that when you plunge a giant needle four times into a tumor mass, then take a scan of that tumor mass, you find damage. Who could have guessed?

Mr. Smith rebutted Feuerstein, saying:

It seems indisputable that we are seeing a biological effectthat we would expect with an immune therapy as immune cells are being attracted to the tumor and are attacking cancer cells.

The fact is that Mr. Feuerstein missed the point in his statement. It is not the needle itself which is causing necrosis and collapse. Instead it is the injection of a liquid - ANY LIQUID - which causes the destruction. Even an injection of simple saline solution into a tumor could cause substantial destruction.

This was later addressed by Dr. Aman Buzdar speaking on behalf of MD Anderson which is involved in running the trials for Northwest. Dr. Buzdar has earned himself the wrath of Northwest bulls due to his criticism of recent promotional statements by Northwest. Nevertheless, he was the official spokesperson for MD Anderson which is running clinical trials for Northwest, such that his views do deserve consideration.

According to Dr. Buzdar:

The weakness of this approach is that there have been many studies in which tumors are injected locally — the injections could consist of anything — and you see tumor regression because of necrosis caused by inflammation

Mr. Feuerstein was therefore wrong about the underlying cause of the tumor destruction. But also, the conclusion presented by Mr. Smith is entirely wrong in itself.

It is far from “indisputable” that this effect is biological at all. If the effect is ultimately determined to be a “physical” effect – ie. simply due to the injection of any liquid causing inflammation – then we are left with a drug that is not having any more effect than saline solution. Investors have therefore relied on incorrect information as having been “indisputable”.

This is a far stronger statement than Northwest itself has ever made publicly about the effectiveness of DCVax Direct. Instead the statement has been communicated in a statement coming from an MDM relationship author.

Example #2 – What about the early release of “interim data” ?

Following the interview with MD Anderson, Mr. Smith made the following statement:

This is an open label trial and it is not unusual for a Company to release interim data before the end of the trial. There is nothing illegal or unethical in doing so as long as the information is accurate. My best judgment is that Dr. Buzdar is speaking for himself and not M.D. Anderson.

Mr. Smith has also stated that:

The phase 1/2 trial is open label which means that results are known to investigators and the Company as they occur.

First off, MD Anderson did follow up with an official statement which noted that:

MD Anderson was not involved in [Northwest's] decision to disclose the [DCVax] study information prior to the completion of the research. Therefore, we felt it was important to state that fact. We also felt it was important to state our belief thatreleasing incomplete research data is not accepted practice in our field.

Dr. Buzdar was in fact speaking for MD Anderson and not for himself. But this is not the point.

The real misstatement that was made by Smith is that this was in any way an “interim analysis“.

This is absolutely NOT interim data being released. Instead it isPATIENT LEVEL DATA being released in an arbitrary manner by Northwest at a time when the results just so happened to be positive. This is highly unusual.

As to the involvement of the trial investigators themselves (as opposed to just Northwest), Buzdar noted that:

Investigators at MD Anderson and the two other hospitals conducting the DCVAX-Direct study have not reviewed or analyzed data at all because patients are still being enrolled and treated. The statements being made by Northwest Bio about DCVax-Direct are derived from patient case report forms, which the hospitals are obliged to send to the company because it sponsored the study

This is of key importance. The data released by Northwest was not interim data and was not even reviewed or analyzed by the investigators involved.

What Northwest did was to put out raw patient level data. Larry Smith then “analyzed” the situation and declared the situation great for the stock. The stock price then soared. This is the promotion technique we see being repeated by those with an interest in Northwest.

It is cherry picking and the selective portrayal of anything that could be viewed as positive. Based on this, it is no wonder that Smith’s readers would buy the stock.

Example #3 – Is PFS an acceptable end point ?

This is another example of a debate between Feuerstein and Smith which has gotten off point. Feuerstein has accused Northwest of “sneaking” in a new risk factor into its 10K, warning that PFS may not be an acceptable endpoint. Feuerstein was mistaken on this point because this risk factor had already been included in a prospectus for a previous equity offering.

When or where this information was disclosed is entirely irrelevant to the real discussion on PFS. The real point of relevance is that Northwest has disclosed this as a risk factor, but Smith has presented compelling reasons to ignore it. But the information he presents is blatantly cherry picked and ignores substantial evidence to the contrary.

The cherry picking of positive evidence in favor of Northwest is the pattern that should be of concern to those who have been relying on Smith’s promotional “analysis”. Readers are guaranteed to see any new developments in the most positive light possible, while ignoring any facts that would raise concerns about Northwest.

In its recent disclosure, Northwest has included the following risk factor:

The primary endpoint of our Phase III trial is progression free survival. Sometimes regulators have accepted this endpoint, and sometimes not. There can be no assurance that the regulatory authorities will find this to be an approvable endpoint for Glioblastoma multiforme cancer.

Yet Mr. Smith stated flat out in an article that “Progression free survival is a solid primary endpoint for DCVax-L phase 3.” He then went on to basically tell readers to ignore the risk factor altogether, stating:

As everyone knows, lawyers write risk factors that try to cover any possible event. I remember one that recently warned that the Company’s production facility which was in a west coast city was at risk of being destroyed by a tsunami.

The debate over the appropriateness of PFS continues. Everyone is entitled to their own view.

But the acceptability of PFS will ultimately prove to be of key importance for DCVax-L. If it turns out that the FDA will not accept DCVax-L based on PFS, then the whole trial largely becomes a moot point. The drug will simply fail due to improperly selected endpoints.

As always, Mr. Smith is able to find impressive evidence to support his view, which also happens (of course) to be very beneficial to Northwest.

Mr. Smith states:

In rapidly progressing cancers, there are credible opinion leaders who believe that progression free survival is a very good endpoint. In a recent article in Neuro-Oncology, the authors concluded:

“In glioblastoma, PFS and OS are strongly correlated, indicating that PFS may be an appropriate surrogate for OS. Compared with OS, PFS offers earlier assessment and higher statistical power at the time of analysis.” Here is the link to the article is as follows:

Another recent video also goes into a discussion about using progression free survival as an endpoint in metastatic melanoma, which like glioblastoma multiforme is a rapidly progressing cancer. This is an interesting discussion (link).

Again, Smith has stated information which is factually correct and which clearly supports Northwest. But once again, Smith has also deliberately cherry picked information which will put Northwest in a positive light.

If I wanted to paint a picture that PFS is an approvable end point, I could certainly do so also. What I would do is just what Smith has done. I would provide quotes from parties (similar to Northwest) with an interest in drug development. These are the ones who WANT to see PFS used because it makes it easier for their drugs to get approved.

This is akin to providing quotes from big oil companies about their views on the environmental impact of burning hydrocarbons. Everything is apparently just fine.

Alternatively, I could also present an equally compelling case that PFS is NOT an approvable endpoint because it delivers no real benefit to the patient. It is “measurable” but it is not meaningful. This is why the FDA has been reluctant to accept it.

I can find equally prestigious doctors and scientists to support a very strong view against the use of PFS.

For example in the Journal of Clinical Oncology it is noted that:

It is time for the oncology community and regulatory agencies to take a hard look at PFS and challenge its growing use [by pharmas] as a primary efficacy end point. There should be good evidence for its ability to predict improved QOL or OS improvements if it is to play a central role in defining new standards of care. If it does not have these properties, we must measure the true end points of importance to our patients, andnot something that has as its chief advantage ease of measurement or speed of trial completion.

This came from a doctor who happened to have no conflicts of interest with the drug industry.

The following abstract addresses some of the inherent biases in PFS.

For those who following the oncology space, it should be clear that relying on PFS for approval is in fact a major risk. Smith had cited the approval of Avastin for use in glioblastoma multiforme based on PFS.

But – of course – he neglects to note that the previous approval of Avastin for breast cancer was revoked due to lack of OS benefit. Again, this is cherry picking facts in order to portray Northwest in the best light possible.

Example #4 – Prospects for revenue from Germany ?

Here Mr. Smith was very cautious in his choice of words. But the end result was that he planted the $50,000-$100,000 number into the heads of readers and investors. It is a very big number and many investors have now incorporated that into their expectations.

My speculation is that the price of the drug will be in line with that of breakthrough cancer drugs or roughly $50,000 to $100,000 per year. I want to re-emphasize that the Company absolutely refuses to make any comment on my price estimate until reimbursement negotiations are concluded.

Clearly Smith has included (and re-included) massive caveats here that management refuses to comment. So what we have instead of a comment from Northwest is Smith planting the $50,000-$100,000 number into the heads of readers in a way that can be walked away from when it doesn’t happen. In the short term, it still managed to get investors into the stock.

Yet we know clearly that Northwest cannot actively market the drug into Germany. And even Northwest itself has repeatedly likened the German program to “compassionate use“. Reimbursement at the level of $50,000-$100,000 is borderline nonsense.

Northwest has indeed refused to comment. But the number still got out there, now didn’t it ? This is why it is crucial to have such articles come out from various authors.

Example #5 – What are the odds of approval ?

The other related writers are far less cautious in their wording than the Wall Street trained Smith.

For example, Austrolib states that:

DCVax-L still has a good chance of being approved. And all sides agree that DCVax-L’s side effect profile will most likely come in benign, as side effect profiles tend to do for other autologous vaccines.

Clearly no management team would ever make such bold statements themselves in an actual press release. But instead, an author with clear ties to Redfish clients made it for them.


Investors in Northwest Bio and a variety of other biotechs now have every right to be concerned about their supposed “due diligence”. Much of what they have been relying on is either misleading or wrong.

Dozens of fake articles have been written by fabricated authors in attempts to elevate the stock price. The message boards are being infiltrated by shills who run deliberate campaigns. Readers are completely unaware that such campaigns are conducted.

Even the prestigious Larry Smith of Smith on Stocks (the biggest Northwest bull) has been concealing volumes of relevant information from his readers, including his close relationship with MDM Worldwide, his troubled past and his historical IR activities. Only after knowing he was caught has Smith reluctantly begun disclosing limited amounts of this information.

Various parties involved, including Smith and MDM, have stated clearly that there has never been any payment made for articles.

Yet the emails I obtained from John Eastman suggest otherwise in many cases. Backing up the information from Eastman is the fact that hundreds of articles on MDM clients have all been written by the same group of authors and have delivered glowing portrayals of MDM clients.

These authors were all created in the same narrow time frame to cover the same stocks that Smith was covering and with the exact same bullish views. And they all happen to be MDM clients.

Some retail investors may still take the view that

I don’t care if the stock was promoted, I believe in the prospects for the drug

Again and again, such a view has proven to be naïve and expensive.

First — many smarter investors will quickly realize that they probably do not understand Northwest or DC-Vax nearly as well as they thought they did. Smarter investors will realize that much of their supposed knowledge and perceptions about Northwest have absolutely been shaped by a promotion that was designed to create favorable perceptions of the company. Most investors only really “know” what these authors have told them. Upon reflection, this should be obvious and it should be very concerning.

Second — if the company did in fact have such strong prospects (as touted by the bullish promoters) then there would be no need for anyone to engage in undisclosed stock promotions, which could truly put at risk the entire future of the company. The simple fact that anyone engaged in a stock promotion raises serious doubts about the underlying fundamentals.

Third — the fact that the promotion (now exposed) is going to stopmeans that the share price will likely fall on its own. This is what we have seen with past promotions. Once a promotion pushes the stock up, it is imperative for the promotion to continue. This no longer becomes an effort to make the stock rise any further, but instead is an effort just to keep the stock from falling on its own. This is why we see so many repeat articles from the same authors. Once these authors are exposed, the articles stop. Then the share price inevitably falls. Every single time. This is just how stock promotions work.

Northwest has clearly been paying MDM for “social media” and / or “content” services over the past two years. During this time, there was a noticeable and dramatic surge in promotional articles being written on Northwest.

These articles were overwhelmingly coming from authors with ties to MDM, including Redfish which indicates that it get paid to write articles. Many of these authors are using false names and fabricated credentials.

As shown in the table in Section II, nearly every public company which is an MDM client also happens to have had a large ongoing stock promotion involving the same small group of authors to write on all of the stocks. I encourage readers to re-read the table above which shows the overlap between the fabricated authors and the MDM clients on which they wrote.

The takeaway from the points above is that even investors who still hold on to bullish views on a company’s drug prospects (despite the knowledge of a promotion) should not be surprised to see the stock fall dramatically now that the promotion has been exposed.

The last few stock promotions I exposed (found here and here) were primarily biotech stocks with various oncology drugs. Following my articles, many small retail investors quickly defended the stock on the basis of the drug’s prospects which they felt they had thoroughly researched. These stocks are now mostly down by at least 40-60% following the exposure of the promotions.

Notes: The author did attempt to contact management at Northwest Bio in the week before publication but Northwest did not respond with answers to questions. The author did attempt to contact Larry Smith for comment in the week before publication, but Mr. Smith did not respond to an email. The author did attempt to contact Adam Feuerstein for comment in the week before publication, however Mr. Feuerstein was on vacation and was not available for comment.

Disclosure: The author is short NWBO. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The author was previously an investment banker for a major global investment bank and was engaged in investment banking transactions with a wide range of healthcare companies including medical device, pharmaceutical, genomics and biotech companies. The author has not been engaged in any investment banking transactions with US listed companies during the past 5 years. The author is not a registered financial advisor and does not purport to provide investment advice regarding decisions to buy, sell or hold any security. The author currently holds a short interest in NWBO and has provided fundamental and/or technical research to investors who hold a short position. The author may choose to transact in securities of one or more companies mentioned within this article within the next 72 hours. Before making any decision to buy, sell or hold any security mentioned in this article, investors should consult with their financial adviser. The author has relied upon publicly available information gathered from sources, which are believed to be reliable and has included links to various sources of information within this article. However, while the author believes these sources to be reliable, the author provides no guarantee either expressly or implied.

The ugly truth behind Ohr Pharma (OHRP)


Over the weekend, physician Michael Sacerdote penned an article discussing Ohr Pharacuatical (OHRP) which was quite thorough and scientifically rigorous. He posted three major conclusions:

First, despite the apparent clinical efficacy of squalamine, the drug would be a commercial failure because it does not reduce the need for overall injections into the eye.

Second, with any possible approval being at least 4 years away, the drug will be too far behind rival Opthotech’s competing drug, Fovista. This again will result in commercial failure.

Third, the value of squalamine is zero.

Dr. Sacerdote is a physician and his scientific analysis reflects that. However, I do believe that the doctor has missed the much larger point with Ohr and squalamine.

In fact, this drug never had a real shot at success in the first place. The information gleaned from recent phase 2 trials has been known for more than 10 years. Yet the drug was already determined to be commercially unviable and was effectively discarded by its previous owner for de minimis proceeds.

Most importantly, the recent surge in the stock has simply been the result of a stock promotion provided and paid for by Ohr management. It has nothing to do with the prospects for squalamine and everything to do with management’s desire to issue more stock in equity offerings going forward. Ohr currently has a market cap of $250 million and less than $20 million in cash, with no near term drug prospects.

Recent developments

Shares of Ohr Pharma have been extremely volatile lately. The stock is held overwhelmingly by retail investors who can be easily influenced by small amounts of publicity, even when the underlying data is clearly not well understood.

On June 23rd, shares of Ohr rose by 16% due to the following announcement:

Ohr Pharmaceutical Announces Positive Interim Top-Line Clinical Results From Phase II Study of Squalamine Eye Drops in Patients With Wet AMD

Clearly the headline was very positive. And the contents within the press release were also very positive.

But the devil was in the details.

In fact, buried deep within the press release was the fact that squalamine actually missed its primary endpoint. The goal of the entire study was to reduce the frequency of Lucentis injections and this did not happen. The drug failed its objective. Period.

But given the incredibly positive spin, it was not at all surprising that retail investors bid the stock up. It was also not surprising that self-appointed biotech vigilante Adam Feuerstein was quick to cry foul.

One day later, Feuerstein pointed out the fact that the drug had actually failed. He also called management to task for the incredibly deceptive press release. Within two days, shares of Ohr were down by as much as 40%, briefly hitting $6.86, down from $11.40 post press release.

Yet within two more days, shares of Ohr were again up by as much as 60% from those lows, briefly hitting $10.97 again. The main contributor to this surge was an “upgrade” by Vista Partners which placed a new $31 price target on the stock.

Lest anyone miss their upgrade, Vista even put out a press release to trumpet it and included the key reasons for why Ohr should be a $31 stock.

Vista Partners Updates Coverage on Ohr Pharmaceutical, Inc. (NASDAQ:OHRP); Raises Price Target to $31

The bullish upgrade and the soaring share price were then further amplified by media sources such as Benzinga and TheStreet.com.

But there is one major problem here. The report issued by Vista (including the $31 target) was fully bought and paid for by Ohr management.

This fact was not disclosed in the press release by Vista and was therefore missed by both Benzinga and TheStreet.com (as well as other market sources). It was also clearly unknown to the retail investor base and it appears that very few people appear to have read the actual report from Vista Partners.

For those who wish to read the actual Vista report, I have included a pdf copy at moxreorts.com.

But it gets worse.

Buried deep on page 10 of the report, and in much tinier font, is the disclosure from Vista that:

This report has been prepared by Vista Partners LLC (“Vista”) with the assistance

OHR Pharmaceutical, Inc. (“the Company”) based upon information provided by the Company. Vista has not independently verified such information, and in addition, Vista has been compensated by the Company for advisory services for a one year period. Vista and its officers may have an equity interest – both restricted and unrestricted in the securities mentioned herein.

The key points to understand are as follows:

  1. The information in the Vista report was provided solely by Ohr management itself
  2. Vista then does not even bother to verify any information
  3. Ohr pays Vista for “advisory services” which includes putting out reports like this one.

The report from Vista is nothing more than a late night infomercial provided by Ohr management, yet it caused the share price to soar by 60% in two days.

It is very clear from the share price reaction that the heavy retail base of investors in Ohr did not even bother to read this report. If any of them did, they certainly did not find the tiny disclosure buried on page 10. Certainly Benzinga and TheStreet.com missed this.

So Strike One for Ohr is the misleading press release on June 23rd which painted a failed clinical trial in a stunningly positive light.

Strike Two is the use of a paid stock pump to further elevate its shares using a $31 share price target and a firm which doesn’t even bother to verify the information provided solely by Ohr.

Looking at the history of Ohr will reveal Strike Three.

It is the fact that squalamine largely never stood a chance at getting approved or of achieving commercial success in the first place. The drug was purchased for next to nothing after it had already failed to prove itself viable in clinical trials. It was largely just an excuse for Ohr to run a stock promotion with the goal of issuing stock to raise tens of millions of dollars.

The history of Ohr Pharma

Ohr Pharma was created in a simple reverse merger transaction in 2009, which was arranged by financier Orin Hirschman. Mr. Hirschman then appointed his father Shalom Hirschman to act as a consultant to oversee the purchases of various small and inexpensive pharma assets. By this time, the father had already sold to the corporate entity several “pre-clinical” drug assets in exchange for warrants on 5 million shares with a strike price of just 50 cents. Not a bad deal for mere “pre clinical assets”. The son already owned 18.9% of the public company by virtue of having arranged the reverse merger.

The company then appointed fellow financier Andrew Limpert to serve as its CEO. According to SEC filings, Limpert had (up until the previous year) been a control person for an investment advisor known as Belsen Getty. He also served various roles such as chairman and CFO of two publicly traded reverse mergers, Nine Mile Software and Profire Energy. For reference, SEC filings then describe the fraudulent activity, settlements and cease and desist orders involved from then CEO Limperts activity with manipulation and non-disclosure in these other reverse merger stock deals.

Later in 2009, with Limpert at the helm, Ohr completed the acquisition of Squalamine, Trodusquemine and related compounds from Genaera Liquidating Trust. The Company paid a mere $200,000 in cash for all of these compounds.

The cost per compound therefore comes out to something well under $100,000 each. We don’t know exactly how many compounds were purchased in this basket transaction so we can’t determine the exact average cost.

The first question becomes: why were the Hirschman’s and Limpert able to acquire these compounds so cheaply ?

The answer is that they arguably had no value whatsoever.

Squalamine was acquired from a Pennsylvania biotech company calledGenaera which had just wound down and liquidated its remaining assets for just a few pennies per share in June 2009. Among the “assets” being sold off were the rights to squalamine (for age related macular degeneration), trodusquemine (for obesity and now breast cancer) and various other compounds. (Genaera had previously attempted to develop squalamine under the trade name EVIZON).

Despite being shopped to dozens of potential bidders, the compounds failed to attract high bids and Ohr was able to walk away with the rights toall of these various compounds for just $200,000.

These assets were basically given away in bulk, and for a very good reason. In 2007 (two years BEFORE going out of business) Genaera disclosed that:

Additionally, preliminary information on subjects enrolled in Study 212 suggested that EVIZON™ was unlikely to produce vision improvement with the speed or frequency necessary to compete with recently introduced treatments. With this information, as well as evolving guidance from the FDA on clinical endpoints, we concluded there was no pragmatic option for the registration and commercialization of EVIZON™ for the treatment of wet AMD.

The drug was a failure and it was basically being given away as part of a bulk package of compounds for a nominal sum as part of winding up a bankrupt company.

But what is interesting here is to note that the original optimism by Genaera for the drug was based on vision and visual acuity, including “up to 8 lines” of visual acuity improvement. Sound familiar ?

The key point to understand is that these optimistic views on the efficacy of squalamine were expressed in a Genaera presentation to investors - in 2003 !!! They are nearly identical to what Ohr just disclosed in 2014 – 11 years later.

Ohr had absolutely no basis whatsoever for pretending to be surprised at any new and positive results. The company knew that in-line results should have been achieveable since the day they bought the drug.

Had these results actually mattered, they would have been used as the primary end point for the study. But they did not matter, so they were not used.

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Now it is 2014, and a subsequent test of squalamine (not surprisingly) yields very similar results. Ohr had reported in its press release that “Percentage of Squalamine plus Lucentis PRN-treated patients gaining three, four and five lines in visual acuity was more than double the placebo plus Lucentis PRN arm”.

It sounds great. But does it matter ?

We can see that in 2014 the results that are being reported by Ohr are in fact slightly worse than the results we saw back in 2003. And even with those slightly better results reported by Genaera in 2003, the drug was ultimately abandoned as being irrelevant and commercially unviable. Aside from Ohr, no one was even willing to pay a meaningful sum for this discarded drug.

This was a drug with no real commercial value. Genaera was happy to basically give it away as part of a basket package deal.

What is the point of all of this ?

Once again, Ohr is being incredibly misleading by pretending that these results are new or are any sort of surprise. These results are simply a repeat of similar information which had been released 11 years earlier.

In fact, Ohr would have been fully aware of these findings in 2009 when it purchased the drug from Genaera. The latest press release is nothing more than a ruse to get the stock up. And the ruse was then repeated and trumpeted by Vista Partners (the firm that doesn’t verify any information provided by Ohr management).

The second question becomes: why would Ohr even bother taking an already failed drug through clinical trials ?

This is something we see all too often in the world of microcap reverse merger biotechs. A company buys a drug “asset”. The result is not to buy the best drug. Instead it is to buy the cheapest drug asset it can find and then simply maximize the hype surrounding it. The stock soars and the company raises tens of millions by selling stock. This capital raised can hopefully be used later on to buy or develop a real drug, one that actually might work. In the meantime, executives and directors pay themselves hundreds of thousands per year in salaries while they wait.

By 2010, Ohr had purchased a small variety of compounds from different sources. Total cash outlay was well under $1 million such that the cost for each compound continued to be negligible. The company then took on new management with more “marketable” credentials than Mr. Limpert.

Dr. Irach Taraporewala was appointed CEO with a base salary of just $61,000 plus some stock. It turns out that Dr. Taraporewala was an associate of Shalom Hirschman (the father), with both of them working together at an OTCBB penny stock company called Advanced Viral Research. That firm went bust in 2009, just as Orin Hirschman was assembling the Ohr reverse merger. The timing was therefore perfect.

The Hirschman’s then appointed Sam Backenroth as CFO. Mr. Backenroth was just 26 years old with two years of work experience and had no experience as a CFO. His starting salary was $24,000.

The point from all of this is that the goal is not to “succeed at any cost” like a true pharma company. Instead it is a strategy known as “fake it ’til you make it“.

Acquire assets and people with minimal value or relevant experience and then spin an impressive story around some massive future potential. When the stock soars, raise as much money as possible to create as much “disposable capital” as possible.

In this way, the financiers can turn an investment of a few hundred thousand dollars (used to purchase defunct compounds) into “disposable capital” of tens of millions.

When the stock needs a little help, management can always rely on stealthy paid reports (such as from Vista Partners) and misleading press releases to help boost it up a notch. In addition, by building relationships with a few small cap investment banks, these types of companies can occasionally get bullish sell side coverage. It is obvious to these banks that companies like this will be frequent investment banking clients due to the never ending need for capital.

This is the formula for reverse merger riches, and I feel that I am seeing it clearly once again in Ohr. The only problem is that ordinary share holders find themselves sitting on a serial dilution machine due to the never ending stream of equity offerings. Meanwhile those behind the promotion can simply award themselves more and more stock options to maintain their ownership.


Dr. Sacerdote came to the conclusion that “Value of Ohr’s squalamine eye drops for wet age-related macular degeneration is $0 or less”.

I entirely agree with Dr. Sacerdote’s conclusions, but for very different reasons. Dr. Sacerdote makes reference to such items as the “biological activity” and “molecular weight” of squalamine. I see this analysis as being accurate but largely unnecessary.

Squalamine was purchased for a negligible cost from a bankrupt pharma because it had already failed and was clearly worthless. Dozens of other buyers had the opportunity to bid on squalamine and no one was willing to pay a material price.

Ohr acquired the cheapest compounds that it could and then appointed the cheapest management that it could. There was never any real chance of these compounds succeeding.

Instead, Ohr has used misleading press releases and stealthy paid “research reports” to boost its stock price and raise money via stock sales.

Ohr Pharma is little more than a fools game for retail investors which has been engineered by clever financiers.

As or now, Ohr has around $20 million in cash and no material tangible assets. It’s drug compound portfolio should be evaluated in the context of the facts provided above. Against this, the market cap of Ohr is still over $200 million.

As investors come to terms with the stock promotion and the questionable assets, the stock will likely fall by at least 50%.

Even though much of Ohr’s current approx. $20 million in cash was raised in April, the recent efforts at pumping the stock tell us that we should be on strong lookout for more equity offerings coming up due to the fact the Ohr has zero near term revenue prospects.

Disclosure: The author is short OHRP. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The author was previously an investment banker for a major global investment bank and was engaged in investment banking transactions with a wide range of healthcare companies including medical device, pharmaceutical, genomics and biotech companies. The author has not been engaged in any investment banking transactions with US listed companies during the past 5 years. The author is not a registered financial advisor and does not purport to provide investment advice regarding decisions to buy, sell or hold any security. The author currently holds a short interest in OHR and has provided fundamental and/or technical research to investors who hold a short position. The author may choose to transact in securities of one or more companies mentioned within this article within the next 72 hours. Before making any decision to buy, sell or hold any security mentioned in this article, investors should consult with their financial adviser. The author has relied upon publicly available information gathered from sources, which are believed to be reliable and has included links to various sources of information within this article. However, while the author believes these sources to be reliable, the author provides no guarantee either expressly or implied.

Synageva setting up for big disappointment


  • Investors and analysts have overestimated the market size for SBC-102 by at least 3-9x.
  • Most sufferers of CESD can be treated by proper diet and common statins (ie. Lipitor) without the need for a $300,000 drug.
  • Management has now sold 95% of its stock, reducing combined holdings to less than 1% of outstanding – even before their drug has completed trials.
  • Similar to Raptor and Aegerion, Synageva will likely drop by at least 50% from current levels.

[Note: just prior to publication of this post, an article appeared in the European Atherosclerosis journal entitled "Lysosomal acid lipase deficiency - an under-recognized cause of dyslipidaemia and liver dysfunction". The article contains references to many of the studies and issues which I have referred to below. That article was supported and funded by Synageva and Synageva researchers and is available for purchase via ScienceDirect.]

Company overview

Synageva BioPharma (GEVA) is a $2.6 billion biotech which specializes in developing drugs for very rare diseases. The company came public via a reverse merger in 2011 with failed biotech Trimeris. At the time of the reverse merger, legacy company Trimeris was held 36% by the Baker Brothers. Recent purchases by the Bakers have served to maintain (but not increase) this stake in the venture. Following 5 large equity offerings raising over $600 million from stock sales, the Bakers continue to currently hold just 35% of the renamed company, Synageva. The Bakers have made it their practice to buy into each of these equity offerings, typically in proportion to their ownership stake.

Synageva currently trades at around $75 per share and has a current cash balance of around $600 million (equivalent to around just $18 per share in cash). The company expects to lose $190-205 million in 2014. The company lost $95 million in 2013.

Short interest in the stock has gradually declined over the past few months, and now sits at just 4% of shares outstanding.

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In 2013, Synageva derived $13 million in total revenues from royalties on AIDS drug FUZEON along with additional collaboration revenues. But both of these revenue sources are declining and neither is material to the $2.6 billion valuation at present. Synageva has no other sources of revenue at present.

Synageva currently has several preclinical programs which it hopes to advance going forward. But for the time being, it has only 1 compound in clinical trials, sebelipase alfa (SBC-102). This is the compound which we will focus on.

During March, Synageva quickly dropped by around 30%. This was largely due to three factors. First, an unexpected (and unnecessary) $200 million equity offering put heavy pressure on the share price. Second was the news that the company expected it would lose around $200 million this year, which was far larger than expected. And third, it was largely the result of concerns regarding pricing developments at Gilead Sciences (GILD) which could affect the broader space of rare / orphan drug developers. Gilead has seen heavy backlash over the perception that prices for its new Hep C drug are simply far too high. The company is now taking steps to address these concerns including providing deeply discounted drugs to certain markets such as Egypt. But this discounting precedent caused Gilead and other drug developers such as Alexion (ALXN) to see similar plunges. These developments are not the primary focus of this article but are still highly relevant to the prospects for Synageva and others. I have included details in Appendix I.

Investment thesis

Synageva’s SBC-102 is highly likely to be approved by late 2014. FDA approval is likely not a concern or a problem.

Yet management has been rushing to sell nearly all of its holdings in Synageva. Management has now unloaded over $50 million in stock, representing more than 95% of its holdings. This has occurred even before its drug completes clinical trials.

CEO Sanj Patel alone has now sold nearly $37 million in stock…and holds less than $100,000 remaining. In April, Chief Medical Officer Anthony Quinn sold more than half of his remaining stock valued $1.7 million.

Meanwhile, the company was also quick to issue new shares in March, raising an extra $200 million that it did not even need. Synageva already had over $400 million in cash on its books.

Although the cash balance is still only $18 per share, this opportunistic offering resulted in Synageva raising far more cash than it needs, simply due to the desire to cash in on a high share price.

It is very easy to see why management has been so quick to sell.

The problems for Synageva are as follows:

  1. The market for SBC-102 is in reality much smaller than has been predicted (as shown below, analysts have over estimated the market size by 3-9x)
  2. Most of those who suffer from CESD have such mild symptoms that they do not require a $300,000 drug (depending on the severity, diet and simple statins like Lipitor will often suffice)
  3. For those with serious symptoms, other more permanent solutions are becoming available via bone marrow and stem cell transplants.

We have seen this exact same phenomenon with other rare / orphan drug developers. There is an initial surge when a company looks set to sell its drug at orphan prices of $100,000-500,000 per patient. The share price surges by hundreds of percent in anticipation of the company becoming “the next Alexion”. But when the market better understands the limited size of actual market, the stock quickly gives up its gains, plunging by at least 50%. Near identical examples are shown with Aegerion (AEGR) and Raptor (RPTP), each of which plunged by 50% or more after their sharp run ups failed.

LAL D / Wolman Disease / CESD

SBC-102 is currently in clinical trials for treatment of lysosomal acid lipase deficiency (“LAL D”). There are two variations of this genetic ailment, one is when it is early-onset (in infancy), while the other is late-onset (typically childhood to young adult).

When LAL D manifests itself in infancy (ie. “early-onset”), there is typically a complete absence of the LAL enzyme leading to harmful amounts of lipids accumulating in the spleen, liver, bone marrow, small intestine, adrenal glands and lymph nodes. Symptoms which follow include enlarged liver and spleen (hepatosplenomegaly), poor weight gain, low muscle tone, a yellow tint to the skin and the whites of the eyes (jaundice), vomiting, diarrhea, developmental delay, low amounts of iron in the blood (anemia), and poor absorption of nutrients from foodThis nearly always results in fatality, typically before age one. When describing early-onset LAL D in infants, it is known as Wolman Disease (“WD”). There is currently no approved treatment on the market for WD.

When LAL D manifests itself later in life, there are a wider variety of outcomes buy viagra online and severities to the deficiency. Unlike early-onset WD, the enzyme is present, but it is present in a malfunctioned form. In this latter case, it is known as Cholesteryl Ester Storage Disease (CESD). More information on the wider variety of outcomes due to CESD is provided below.

What is driving the $2.6 billion valuation of Synageva ?

Both manifestations of LAL D (ie. both early-onset WD and late-onset CESD) can be considered ultra-rare afflictions. But only with WD is it ultra severe (life threatening) in all cases. SBC-102 has been granted orphan drug designation in theUS and inEurope, and has been granted Fast Track Designation by the FDA.

Terms like “ultra rare”, “orphan drug” and “fast track” often result in premium valuations for the drug companies who can attain them. What these terms mean are that a drug is likely to come to market more easily, more quickly and at a tremendously higher price than for normal drugs.

For example, Alexion currently trades with a market cap of nearly $30 billion even though it markets only a single product sold to a few thousand patients. That product is Soliris, for treatment of several ultra rare immune disorders. The cost for Soliris: over $500,000 per patient.

In 2013, Alexion brought in over $1.5 billion in revenue, implying a total patient count of around 3,000 (perhaps slightly more, assuming some discounting in price takes place). Beyond just revenues, Alexion has also been highly profitable with this one drug. Even after R&D and selling expenses, Alexion was able to achieve operating margins will in excess of 25%. In 2013, net income was $252 million, putting Alexion on a PE of over 100x.

If Synageva held any such bullish prospects, then it would certainly be very difficult to reconcile this with the wholesale liquidation of stock which has gone on by the key members of management.

As shown in the table below, Synageva management members have been extremely quick to sell nearly all of their shares. They have done this almost as quickly as they get them via option grants.

(click to enlarge)

A list of all of the recent share sales by management has been included as Appendix II. As part of this, it can be seen the CEO Patel continued to sell nearly $10 million in stock this year. He now holds just $77,000 in stock. In April, the CMO sold more than half of his remaining stock. This follows sales of nearly all stock by other key members of management.

The purpose of the analysis that follows is to explain WHY management has expressed such urgency in selling nearly all of their shares of Synageva as quickly as possible.

Will SBC-102 be approved for WD and CESD ?

The answer is an almost certain “yes”. Even the bears on Synageva should agree that SBC-102 will be approved by the FDA without issue.

The real issue for investors is that there are three majorcommercial problems facing SBC-102, which explains management’s heavy share sales.

Problem #1: the total addressable patient population has been dramatically overestimated.

To evaluate this problem, we need to look at the two afflictions (WD and CESD) separately.

There is little debate about the fact that (early-onset) WD in infants is an ultra rare affliction. In fact, it would more aptly be described as ultra-ultra-ultra-ultra-rare.

According to the NIH, WD is expected to occur in just one out of every 350,000 live births. That means just 8-10 cases per year in theUS.

The numbers for WD are so small and are tied to new births such that that even if SBC-102 were to replace Soliris as the world’s most expensive drug, the total revenue it might realize would still not even justify the cost of the clinical trials and R&D.

So then WD is not where Synageva’s ambitions have been stated for commercial purposes. Instead, it is the hopes for treatment of (late-onset) CESD that have propelled the stock higher.

In attempting to size this market, the primary study being cited by Synageva management and analysts was one conducted in Germanywhich came to the conclusion that CESD should have a prevalence in the general population of about 1:40,000. That equates to 25 patients per million, or about 7,500 total affected individuals in theUS.

In its corporate presentation, Synageva has cited a wide ranging number from 1:40,000 to 1:300,000 and used multiple studies, blending together the ultra rare WD with the more common CESD. But it is clear from their estimates that many analysts have focused heavily on the 1:40,000 number. Morgan Stanley estimates the total patient population at exactly 7,500 people (exactly in line with 1:40,000). Wedush tones this down a bit and estimates it at just over 5,000.

What these sources fail to mention is that the German study was NOT a measurement of the incidence of CEDS in the German population at all. Instead it was a simple extrapolation of what might be expected in the overall population ofGermany based on a gene mutation model applied to just 2,023 individuals. This is very important.

The findings from this genetic modeling exercise were certainly not a clear cut measurement. This can be illustrated by the clumsy wording of the conclusion of the study. It comes to its 1:40,000 (25 per million) number by stating:

Assuming Hardy-Weinberg equilibrium, the homozygote carrier frequency can be estimated to 6 per million. Applying these results to the German general population, about 91 E8SJM homozygotes aged 18 years or younger would be expected. Under the assumption that this mutation represents about 50% of all CESD-causing mutations, the prevalence of CESD (homozygotes or compound heterozygotes) among German newborns is estimated at 25 per million, or a total of 366 cases under the age of 18.

After reading that paragraph, most readers likely walk away simply saying “huh ?!?”

The point to this very clumsy conclusion should be obvious. It does not even remotely resemble a statement that 25 people per million actually HAVE CESD. It is just an exercise in genetic modeling.

But for marketing purposes of SBC-102, all that mattered was obtaining a hard number which justified large revenues. In this case, that number was a hard and fast 25 per million.

Yet many seem to have ignored the very next (and most important) sentence in this German study, which states:

This estimate is in apparent conflict with the small number of CESD cases reported in the literature.

The “apparent conflict” and the “small number” of CESD cases should be very obvious. What it means is that IN REALITY, we don’t find anything even remotely near a 25 per million incidence of CESD.

According to the NIH website in 2007 (the same year as the German study)

Cholesteryl ester storage disease appears to be a rare disorder. About 50 individuals affected by this condition have been reported worldwide.

Since that time, and with the onset of clinical trials for a specific drug targeting CESD, there have been efforts by Synageva to increase awareness and reporting such that it should be expected that this will have increased from just 50 cases over the past 7 years.

Much of the reason for the low reported incidence of CESD is simply due to the fact that the disorder is “considered a benign indication” in most cases. It can in fact be treated by simple changes to diet and the uses of fairly simple statins such as Lipitor. As a result, it is often never even reported as a disease at all. This will be described further as part of Problem #2.

But it should also be noted that a more recent USstudy conducted in 2013 evaluated the incidence of CESD across various racial groups and estimated prevalence at 1:130,000. In other words, the “apparent conflict” disclosed in the German study and being used by the research analysts (ie. bankers) is that these numbers are overstated by 300%.

Some of the bankers do get credit for paying attention to the wide spread in the numbers presented by management. For example, Nomura points out the oddly large size of the variation between managements estimate of 1:40,000 and 1:300,000. Nomura then settled on a number in between at 1:150:000. That is about 7 per million, instead of 25 per million.

Not surprisingly, this resulted in Nomura placing a target on the stock that is $20 lower than Morgan Stanley. Morgan Stanley is clearly estimating a market size that is around triple that of Nomura.

Goldman Sachs took a similar approach, and an even smaller market size, and ended up with a $72 share price 12 month target upon initiation.

But moving into the next section, we can see that the real problems are about more than just debating the numbers. This is where all of these analysts are much further off, and why their share price targets will ultimately be cut in half from current levels.

Problem #2: unlike WD, many who suffer from CESD face very mild symptoms

With early-onset WD, the implications are categorical. There is a complete absence of the LAL enzyme. Symptoms are severe and if it is left untreated the individual will not survive. The entire purpose of having orphan drug status is to incentivize drug companies to develop treatments for underserved “orphan” areas such as WD.

But again, due to the ultra low incidence of WD, this is not where Synageva’s actual commercial hopes lie. Even at ultra high prices, there are simply not enough cases of WD each year to generate adequate revenue.

Synageva hopes to commercialize SBC-102 mostly for treatment of the (relatively) more common late-onset CESD.

The problem is that when it is late onset as it is with CESD, the symptoms are not black and white as they are with WD. In CESD, patients have a mutation to the enzyme (rather than a complete absence) and therefore still express some amount of enzyme. However, it has varying degrees of functionality.

According to the National Organization for Rare Disorders (NORD)

The symptoms and severity of cholesteryl ester storage disease (CESD) are highly variable from one individual to another. Some individuals may develop symptoms during childhood; others may have extremely mild cases that cause few symptoms. Still other individualsmay not have any noticeable symptoms (asymptomatic) and may go undiagnosed until well into adulthood.

Under the section entitled “treatment”, NORD goes on to note that

A hypolipidemic diet and statins are the main therapeutic toolsused against CESD. …The combination of diet and drug administration has led to dramatic reductions in the levels of lipids such as cholesterol and triglycerides in the blood of affected individuals.

It is from observations such as these from NORD that we can see that the severity of a LAL D diagnosis can vary quite widely from life threatening at one extreme to just heavy nuisance at the other. It is also safe to say that those in the nuisance category are not going to be spending over $300,000 on an ultra rare orphan drug. Instead, they will monitor their diet more carefully and take a statin such as Lipitor.

Obviously, with the most severe cases of CESD such mild treatment would not suffice.

Yet current sell side analyst estimates are calculated based on the assumption that the vast majority of all individuals who could be considered to have a CESD diagnosis will require the $300,000 drug.This is simply wrong.

This is not to say that CESD is without the potential for serious, life threatening consequences – in SOME cases. NORD goes on to note that:

In most cases, CESD is considered a benign condition, but insome cases significant complications may eventually develop including fatty liver (liver steatosis), fibrosis and finally micronodular cirrhosis with liver failure and esophageal varices due to altered hepatic venous circulation. The vessels swell and sometimes may rupture, causing potentially life-threatening bleeding. Abnormal enlargement of the adrenal glands (adrenomegaly) may also occur in few cases.

The point is that for some small portion of the CESD patient universe, there may be a genuine need for a $300,000 drug. But the size of this paying population is going to be incredibly small, nowhere near the thousands that analysts have been projecting when they have forecast hundreds of millions in revenue.

The point is that the even within the small population that is affected by CESD, most individuals have such minimal symptoms that they certainly will not be paying $300,000 or more for treatment. Many may not even know that it is called CESD. Some individuals that have it may even be entirely asymptomatic.

But there was also some excitement that Synageva has been able to complete enrollment in its Phase 3 clinical trial with over 50 patients. Presumably this would ensure that there is a large universe of patients around the world. Right ?


It is very important to note that the Phase 3 clinical trial “inclusion criteria” are simply that there exists in the patient a “Deficiency of LAL enzyme activity confirmed by dried blood spot ( DBS ) testing at screening”. What this means is that even patients who don’t have debilitating symptoms (ie. the “benign” ones) can be accepted into the trial as long as they simply evidence some sign of LAL deficiency.

As shown above, there are plenty of people who would test positive for CESD without even having symptoms or without even otherwise knowing that they had the indication. These people would certainly be accepted into the trial, but would certainly NOT end up paying $300,000 for the drug.

As a result, the enrollment of the trial is by no means an indication of who might end up actually paying $300,000 for the drug.

Problem #3, for those with a severe need, there are multiple other serious treatment options becoming available. These are permanent, one-time options as opposed to ongoing drug therapy.

As mentioned above, for those with only mild to moderate issues with CESD, there are ways to deal with it which are not burdensome at all. This includes proper diet and the use of drugs like Lipitor. There are also other alternatives such as cholesterol and triglyceride medications.

But even when we get to severe, life threatening cases of WD and CESD, there are still alternatives. These alternatives are very important to consider due to the high price at which SBC-102 will be sold.

CESD is often diagnosed in adolescence, such that a patient might end up being treated for as long as 70 years or longer. With an annual price tag of $300,000 or more, that implies a total cost to treat which could potentially exceed $20 million ! This is certainly an instance where the party paying for reimbursement would want to be well informed of all realistic alternatives.

As early as 2000, this study noted that “Wolman Disease Successfully Treated by Bone Marrow Transplant“. The focus of this procedure was on an infant with WD who would have otherwise died. At age 4, following the transplant, the patient was growing and healthy. This procedure is unlikely to be broadly applicable for WD (ie. for an infant) itself because of the risk of death due to the transplant itself. But it must be remembered that CESD is by definition a late onset of LAL D, such that it will be applicable to older children and adults who could more easily tolerate a bone marrow transplant.

The issue to keep in mind is that bone marrow transplants have successfully been able to permanently treat LAL D, which applies to CESD. The alternative for the patient to consider would be to keep taking a drug that costs $300,000 per year for the rest of his life. Again, this could even exceed $20 million total depending on the age of the patient when diagnosed.

A similar treatment success, but this time with stem cells, was also described in this report entitled “Successful treatment of Wolman disease by unrelated umbilical cord blood transplantation“. Again, the patient treated was an infant, so technically it was treatment for WD. But the results should apply to both WD and CESD (ie. both are simply LAL D with different ages of onset).

The implications are the same. For patients (or their insurers) the decision becomes whether or not to be treated once and for all via a transplant or to continue paying $300,000 per year for life and still be dealing with the unresolved health problem.

So now we know why management has sold virtually all of their stock ! The real world incidence of CESD is as much as 70% less than had been described, the severity of CESD typically does not even merit the $300,000 treatment…and in the few instances where it does, other more permanent options are becoming available.

With these facts in mind, the heavy selling by management becomes quite understandable.

Have we seen the same situation with other orphan drug stocks ? Yes.

Orphan drug stocks are now a red hot topic and have been seen as a source of windfall profits to the biotechs. As a result, we are seeing many of these biotechs overshoot due to hype and excess enthusiasm simply associated with their orphan status.

We can see repeatedly that orphan drug stocks overshoot on the way up when the market gets too excited about their potential to sell drugs for $100,000-$500,000 per year. Once the market better understands the real world potential, the share prices plunge by 50% or more.

For example, Aegerion Pharmaceuticals launched its orphan drug to much fan fare in December of 2012. Yet (just like Synageva) there were contradictory indications provided about the size of the addressable market. These varied by a factor of 10x (ranging from as few as 300 patients to as many as 3,000 potential patients).

In the interim (while there was still hype and uncertainly), the share price quadrupled during 2013, from $25 to over $100, as investors accepted the higher patient number as fact. As the actual performance failed to materialize, analysts were quick to cut their ratings on the stock (after the fact) and the stock is now down by nearly 60% from those highs.

For example, as recently as April 1st, Jefferies cut its price target to $80 from $90. The share price currently sits at around $45.

When the stock was still trading at over $80.00 in November, author Matt Berry had warned of this outcome using easily obtained and publicly available information. His point was simple: the real market size for this drug could in no way generate the kind of revenues to support this $3 billion stock. It was simply a function of market size. As was easily predicted, earnings were a disappointment, and the stock has since been cut in half.

As with Synageva, management at Aegerion were very heavy sellers of their own stock. In the past year, just as the stock was peaking, insiders unloaded over $85 million in their stock. The stock is now down by around 60% since its peak in October. Given the advance warnings and management selling, investors should have known better.

(click to enlarge)

Another nearly identical example is Raptor Pharmaceuticals . Raptor was a $7.00 stock when it obtained FDA approval for Procysbi, but the stock barely budged until it received orphan designation in the US and Europe. These designations, along with ample analyst upgrades, sent the stock to as high as $17.00. When the sales failed to meet expectations due to a smaller than forecast market size, the shares quickly plunged to their current level of around $7.00.

As with Aegerion, investors had ample warning in advance from Gravity Research which predicted the plunge based on overhyped forecasts of the tiny market size for Procysbi. Just like Matt Berry’s analysis on Aegerion, the analysis simply used easily obtainable public information to demonstrate a far smaller market for Procysbi than had been billed. The ultimate outcome was a decline in the stock of 55%. This should have been entirely predictable.

Also like Aegerion (and also like Synageva) management at Raptor has been heavy sellers since the stock peaked out. In the past few months, insiders have sold nearly $7 million and there have been no insider buys.

(click to enlarge)

As with these other orphan drug examples above, investors should have known better.

This dismal performance is all the more notable given the unanimous bullishness given across the board by the sell side analysts. Gravity had included the following table highlighting the research calls expressed on Raptor.

(click to enlarge)

In each of these cases, the information so easily obtained by these independent authors was somehow entirely overlooked by multiple investment banks who happened to be raising money for the companies. This analyst optimism is identical to what we see at Synageva, and we see it even by a number of the same investment banks.

With Raptor, the stock did briefly touch the high share price targets, but only before it fell by 50% to current levels where it now sits. Likewise, the share price targets on Synageva did serve to temporarily lift the stock to those levels before the current decline which we are now seeing.

As these miscalculations become apparent once again, we are also likely to see a decline of at least 50-70% in the share price of Synageva from current levels down to around $30-40. This level of decline would simply see the stock trading back where it was 1 year ago.

Management has no doubt been thrilled with the bullish support from Wall Street analysts, as it has allowed them to sell more than 95% of their shares, much of it in the past few months. These same investment bankers then reaped millions in fees from an equity sale by Synageva in March which raised over $200 million in proceeds.

But what about the big institutional buying by the Baker Brothers ?

Much of the confidence in Synageva stems from the continued buying by the Baker Brothers. In the March equity offering by Synageva, the Baker Brothers purchased 375,000 shares at a price of $105.80. So clearly they were looking to increases their holdings substantially, regardless of price, right ? Wrong.

The Baker Brothers strategy with Synageva has simply been to maintain their original ownership position and avoid dilution. Prior to the reverse merger with Trimeris in 2011, the Baker Brothers owned 36.2% of the company. And now 3 years later, following a continued stream of purchases at every equity offering, they now own 34.89%- ie. almost unchanged. All they have done is maintain their percentage stake in the company which they have owned for years.

This is almost identical to the strategy that we have seen with Dr. Philip Frost in his ongoing purchases of Opko Health (OPK). Dr. Frost continues to buy shares of Opko on a weekly (or even daily) basis, seemingly regardless of price. But what many investors fail to realize is that his ownership position has remained largely unchanged. Unlike, Synageva, Opko has largely refrained from issuing shares for cash and instead has been issuing shares as consideration for a string of acquisitions. In this way, Opko is increasing its number of “shots on goal”.

Were it not for his open market purchases, Dr. Frost would see his ownership stake in the company fall dramatically due to the for-stock acquisitions. But this is far different than the idea that he is conducting a “creeping takeover” (which view has been proposed incessantly by various small investors).

As with Dr. Frost and Opko, the Baker Brothers have an in-price which is at least 60-70% below current levels and a position size which is already large. The implications are two fold: First, incremental purchases vs. the large existing position do not really raise the in-price by very much. Second, with the in-price so low, it becomes nearly impossible to end up losing money on this position unless the stock falls by more than 70%.

With both the Bakers and Dr. Frost, their objectives and constraints are far different for the rest of us, such that they can feel free to continue to buy shares at much higher prices without an impact on their performance. The rest of us cannot say the same.

Author Stock Maustow ran two articles in December highlighting what appeared to be some very attractive trades put on by the Bakers. The premise was that by “following the smart money” we could also make money for ourselves.

Following Smart Money: Baker Brothers LLC Investments In 2013 And Beyond

Following Smart Money: Baker Brothers Investments In 2013 And Beyond, Part 2

The following table shows the results of the investments highlighted in these two articles:

(click to enlarge)

As we can see, simply following the smart money” and buying these Baker stocks would have led to average declines of 24% YTD and 43% declines vs. their recent highs.

The point is not to suggest that the Baker’s are bad investors. Nor is it to suggest that they have simply ridden up a multi year bubble in biotech stock prices. The only point to make is that the Baker Brothers have their own sets of opportunities and constraints which are not applicable to the vast majority of outside investors. Playing follow the leader is the wrong way to invest in biotech stocks. The right way to invest is to evaluate all facts and data and then decide where the most profitable investments will be relative to today’s prices.


As it applies to Synageva, the point should be clear. Common sense is showing us that there are likely to be just dozens or perhaps (at most) hundreds of applicable patients for SBC-102 at prices of $300,000 or more. This is far less than the thousands of patients which would be necessary to justify the current market cap of over $2 billion.

In addition, we can see that many of the potential patients may have symptoms which are so mild that they do not require the high priced drug. For those with severe symptoms, there are already alternative therapies (transplants) which may represent permanentcures rather than ongoing expensive treatments.

Meanwhile, management continues to sell its shares as fast as it can, mostly refusing to retain anything more than token holdings of the stock. So far management members have cashed out of more than $50 million in stock in the past three years. CEO Sanj Patel has personally sold nearly $37 million in stock and currently holds a mere 1,031 shares remaining – almost nothing.

Realistically, we should expect to see Synageva decline by around 50-70% from current levels.

Appendix I – Developments at Gilead and impact on drug pricing

In December the FDA approved Gilead Sciences’ Sovaldi, used to treat hepatitis C. The drug is fantastic. It is the closet thing we have to an outright cure.

It was granted Breakthrough Therapy Designation by the FDA and is effective on 90% of patients in as little as 12 weeks, only involving daily pills.

However, Gilead’s exorbitant pricing of the drug for $1,000 per day or $84,000 for 12 weeks of treatment has caused unbridled backlash from many stakeholders. “Never before has a drug been priced this high to treat a patient population this large, and the resulting costs will be unsustainable for our country,” said Express Scripts chief medical officer Steve Miller. Specialty drugs comprise less than 1% of all US prescriptions but account for ~28% of total spending on pharmaceuticals. Sovaldi is not the most expensive drug in the world, but costlier drugs typically treat extremely rare conditions whereas 130-150M people suffer from hepatitis C globally, 3.2M in the US.

Involved parties are not just idly complaining either. In its first guidelines on treatment of hepatitis C issued in early April, the World Health Organization suggested tiered price discounts by branded drug makers, voluntary licensing, and even compulsory licensing to combat unbearable prices. Express Scripts plans to create a coalition of employers, government health plans, and private insurers and is also working with doctors to delay treatment on many patients until lower-priced alternatives are on the market, probably in 2015. Representative Henry Waxman sent a public letter in late March: “Our concern is that a treatment will not cure patients if they cannot afford it.” Last month, US lawmakers asked Gilead to explain the $84,000 price tag.

With so many pricey drugs on the market, it is curious that this was the drug that finally sparked such an massive outcry about drug pricing. It is particularly notable given that this is for a drug which is extremely effective at treating a very serious problem.

On Friday March 21st (just after the close of stock markets), Gileadannounced that it would be offering the drug to Egypt at discounts of 99% vs. the $84,000 cost.

On Monday March 24th (in reaction to the Friday announcement), shares of Gilead dropped by as much as 6%. Other orphan drug makers such as Alexion and Synageva dropped by 7-10% as well. The message was clear that companies may no longer be free to simply set pricing at the highest level the market will bear. There can be qualitative consequences to even the perception that a company is charging too much for a drug – even when it is an effective drug for a much needed indication.

Appendix II – Stock sales by GEVA management

During 2014, 2014, Synageva insiders have sold nearly $13 million in stock, including over $9 million from CEO Sanj Patel alone. This brings total management sales to more than $50 million. Management has now sold over 95% of its shares. As a result of the recent selling, management now owns less than 1% of the total share count.

Date Insider Name Title Dollars Sold Shares Sold
4/1/2014 Anthony Quinn EVP, CMO & Head of R&D $ 1,670,691 20,000
3/12/2014 Chris Heberlig Group Vice President, Finance $ 755,992 7,670
2/18/2014 Carsten Boess SVP, Chief Financial Officer $ 1,012,369 9,927
1/28/2014 Sanj K Patel President & CEO, Director $ 9,014,999 102,300
12/3/2013 Mark Alan Goldberg SVP, Medical & Regulatory Affairs $ 423,649 7,000
11/18/2013 Carsten Boess SVP, Chief Financial Officer $ 546,857 9,927
11/1/2013 Mark Alan Goldberg SVP, Medical & Regulatory Affairs $ 349,753 7,000
10/1/2013 Mark Alan Goldberg SVP, Medical & Regulatory Affairs $ 450,203 7,000
8/20/2013 Carsten Boess SVP, Chief Financial Officer $ 682,188 14,481
8/16/2013 Carsten Boess SVP, Chief Financial Officer $ 204,121 4,300
7/25/2013 Sanj K Patel President & CEO, Director $ 4,801,679 100,000
7/15/2013 Chris Heberlig Group Vice President, Finance $ 122,249 2,524
7/11/2013 Carsten Boess SVP, Chief Financial Officer $ 622,933 13,237
6/11/2013 Sanj K Patel President & CEO, Director $ 2,845,756 70,000
4/5/2013 Sanj K Patel President & CEO, Director $ 1,570,276 31,605
4/3/2013 Sanj K Patel President & CEO, Director $ 1,954,542 38,395
4/1/2013 Mark Alan Goldberg SVP, Medical & Regulatory Affairs $ 239,831 4,416
3/1/2013 Mark Alan Goldberg SVP, Medical & Regulatory Affairs $ 224,217 4,417
2/20/2013 Sanj K Patel President & CEO, Director $ 3,443,621 70,000
2/1/2013 Mark Alan Goldberg SVP, Product Development $ 210,892 4,417
1/18/2013 Anthony Quinn SVP, Chief Medical Officer $ 473,106 9,447
1/16/2013 Anthony Quinn SVP, Chief Medical Officer $ 278,025 5,553
1/16/2013 Carsten Boess SVP, Chief Financial Officer $ 487,614 9,927
1/2/2013 Mark Alan Goldberg SVP, Product Development $ 209,896 4,417
12/19/2012 Chris Heberlig Vice President, Finance $ 183,705 4,000
12/13/2012 Sanj K Patel President & CEO, Director $ 2,772,438 60,000
12/4/2012 Sanj K Patel President & CEO, Director $ 1,712,105 35,000
11/30/2012 Sanj K Patel President & CEO, Director $ 1,726,818 35,000
10/17/2012 Chris Heberlig Vice President, Finance $ 198,620 4,000
10/16/2012 Carsten Boess SVP, Chief Financial Officer $ 497,650 9,927
9/4/2012 Chris Heberlig Vice President, Finance $ 49,100 1,000
8/31/2012 Sanj K Patel President & CEO, Director $ 3,462,891 70,000
7/26/2012 Anthony Quinn SVP, Chief Medical Officer $ 376,501 7,500
7/19/2012 Anthony Quinn SVP, Chief Medical Officer $ 125,000 2,500
7/18/2012 Carsten Boess SVP, Chief Financial Officer $ 323,091 6,618
6/25/2012 Anthony Quinn SVP, Chief Medical Officer $ 1,056,874 26,000
6/1/2012 Chris Heberlig Vice President, Finance $ 35,733 1,000
6/1/2012 Sanj K Patel President & CEO, Director $ 1,766,318 50,000
5/16/2012 Carsten Boess SVP, Chief Financial Officer $ 1,522,933 39,709
3/23/2012 Sanj K Patel President & CEO, Director $ 1,676,410 50,000
2/27/2012 Chris Heberlig Vice President, Finance $ 165,960 4,500



Disclosure: I am short GEVA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.





Additional disclosure: The author was previously an investment banker for a major global investment bank and was engaged in investment banking transactions with a wide range of healthcare companies including medical device, pharmaceutical, genomics and biotech companies. The author has not been engaged in any investment banking transactions with US listed companies during the past 5 years. The author is not a registered financial advisor and does not purport to provide investment advice regarding decisions to buy, sell or hold any security. The author currently holds a short interest in GEVA and has provided fundamental and/or technical research to investors who hold a short position. The author may choose to transact in securities of one or more companies mentioned within this article within the next 72 hours. Before making any decision to buy, sell or hold any security mentioned in this article, investors should consult with their financial adviser. The author has relied upon publicly available information gathered from sources, which are believed to be reliable and has included links to various sources of information within this article. However, while the author believes these sources to be reliable, the author provides no guarantee either expressly or implied.


Behind the Scenes with Proactive, Inovio and Unilife


Note #1: Prior to publishing this article, the author filed detailed complaints with the US Securities and Exchange Commission regarding the parties and activities described herein.

Note #2: Due to the large volume of documentation obtained by the author, only a small portion is included in this article. However, the author has made efforts to ensure that the SEC and Seeking Alpha are aware of all findings, including those not detailed in this article.

Note #3: Many of the suspect articles referred to below have already been removed by Seeking Alpha. This can be seen by scrolling through Yahoo Finance, where the headlines still remain. However, the author had previously preserved electronic copies wherever possible in order facilitate ongoing investigation of the authors involved.

Investment overview

Following my recent article describing undisclosed stock promotions at CytRx Corp (CYTR) and Galena (GALE), using controversial IR firm The Dream Team Group.

Continue reading…

Behind the scenes with Dream Team, CytRx and Galena

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Note: At least 13 recent articles covering CytRx have been removed from circulation at Seeking Alpha, the Wall Street Cheat Sheet, Motley Fool and Forbes. Many were removed in just the past two days. A list of these removed articles is shown at the bottom of this article. The author has preserved PDF copies of these articles at MoxReports.com.

In total, more than 100 articles tied to The Dream Team have now been removed from circulation in just the past two days.


A few weeks ago I received a surprising email asking me to be a paid stock tout for IR firm “The Dream Team Group”. I was asked to write paid promotional articles on Galena Biopharma (GALE) and CytRx Corp (CYTR), without disclosing payment. Rather than refuse outright, I decided to investigate. I began submitting dummy articles to the Dream Team rep (with no intention of ever publishing them). My goal was to determine how involved management from these two companies were in this undisclosed paid promotion scheme. Below I will provide detailed documentation (emails and attachments) which indicate that management from both Galena and CytRx were intimately involved in reviewing and editing the paid articles on their own stock at precisely the time they were looking to sell / issue shares.

Continue reading…

Links to pulled articles on CYTR

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The following is a partial list of archived articles on CytRx which have been removed from circulation.  I expect to continue uploading additional articles on CytRx and other Dream Team clients going forward.













Sungy Mobile Set To Burn US Investors


Company overview

Sungy Mobile (GOMO) is a US listed Chinese ADR. The company’s main product is a downloadable “app” for Android phones which allows users to customize their icons and wallpaper. The company currently has a market cap of approximately $900 million and trades on a PE ratio of over 100x. The stock is very liquid and trades $10-15 million (over 400,000 shares) per day. Short interest in the stock is negligible at just 282,483 shares (less than 1% of outstanding).

Investment summary

Sungy represents a compelling short sale opportunity in the near term. At prices above $24, the stock has near term downside of at least 50%, which would still leave it trading above its recent IPO price of $11.22.

Just 2-3 weeks ago, the stock was still trading at around $20, so much of the gains are very recent.

In November of 2013, as China Internet related plays were soaring, Sungy launched an IPO of ADR’s which was downright abusive to investors. Inherent structural problems from the IPO, along with more recent indications of precipitous decline in interest for their products, will likely be the underlying reasons for a dramatic decline in the price. But the actual catalyst for this decline is expected to be the release of the first 20F filing in the next few weeks, along with the upcoming expiration of the IPO lockup.

The IPO’d shares are the only shares which are available to public investors. Sungy walked away with proceeds of $100 million from the IPOand its concurrent private placement. The proceeds are now presumably sitting comfortably in China.

But it is important to note that with the IPO, Sungy set itself up with an unusual dual class corporate share structure where public investors received heavily disadvantaged shares with almost no voting rights and which also happen to have no claim on the underlying assets of the company. Under this dual class corporate structure, US investors get 1 vote per share vs. 10 votes per share for the insiders who hold the special B shares. The result of this is that at the time of the IPO, outside investors put in $100 million in cash but will control less than 4% of the voting power – despite holding 27% of the outstanding shares. It was clearly a great structure and a great deal – for Sungy insiders, but not outside shareholders.

Meanwhile, the operating assets (within the VIEs) themselves remain in separate subsidiaries which happen to be controlled by Sungy management members, Mr. Yuqiang Deng, Mr. Xiangdong Zhang and Mr. Yingming Chang.

For those who wish to better understand the implications and pitfalls of Chinese VIE structures, I had previously written an article at Forbes discussing this topic a while back. For those who wish to read even further, there is a wealth of great information which is updated often atChinalawblog.com. It is safe to say that anyone who does not understand the basics of these structures has no business owning Sungy.

In fact with Sungy, the situation rapidly gets much worse. Buried in the prospectus, we can see that during the IPO process, Sungy was forced to disclose one material weakness along with two significant deficiencies in its internal controls designed to prevent fraud. These were as follows:

  1. Insufficient accounting personnel with US GAAP experience
  2. Insufficient IT control over financial reporting
  3. Failure to maintain ITGC management and security policy

An obvious question might be: So why not simply wait to go public until such serious deficiencies in control could be remedied ?

There are two reasons why Sungy did not wait and instead rushed to get the IPO out the door.

The first reason was that there was simply no need to fix the deficiencies. Even though Sungy is a company based in China, it took full advantage of the United States “JOBS Act”, a piece of legislation which was conceived in the US financial crisis to boost US employment. The Act was finally passed in 2012.

The title of the Act is an acronym for Jumpstart Our Business Startups, and it allows certain companies to apply for “emerging growth status“.

But it might as well be labeled Jumpstart China‘s Business Startups. A number of recent Chinese IPOs have already begun making use of exemptions (a.k.a “loopholes”) within this act which oddly allow even Chinese companies to reduce disclosure and come public despite significant flaws in their internal controls. Examples of recent Chinese companies who used JOBS Act exemptions include Qunar.com (QUNR), 500.com (WBAI) and 58.com (WUBA).

The JOBS Act was a deeply flawed piece of legislation, for these and many other reasons. It was almost a year ago that I wrote about this Act in the context of ServiceNow (NOW), noting that:

Such provisions under the JOBS Act have been controversial. A Bloomberg article entitled

Job-Creation Bill Seen Eviscerating U.S. Shareholder Protections” quoted the former chief accountant from the SEC as saying:

It won’t create jobs, but it will simplify fraud… This would be better known as the bucket-shop and penny-stock fraud reauthorization act of 2012.”

By applying for “emerging growth company” status, ServiceNow can opt to disclose fewer years of financial statements. It is exempt from certain disclosures regarding executive compensation. Investment banks love the provision that allows them to publish research prior to their IPOs – a practice which was banned following the dot.com boom and bust.

Perhaps of greatest concern is that these “emerging growth companies” do not need to have an auditor attest to their internal controls as required by post-Enron Sarbanes-Oxley.

Even though these exemptions should cause anger among US investors, the Act has been extremely popular among new IPO candidates. Although ServiceNow is not a Chinese company, its use of the JOBS Act is also quite inappropriate. When I wrote the previous article, ServiceNow had a market cap of roughly $5 billion – hardly suggesting it should qualify as a “startup”.

In any event, by using exemptions within the “JOBS Act”, Chinese company Sungy was able to come public even despite serious deficiencies in its internal controls. This makes it somewhat worse than other Chinese companies who have used the Act for different exemptions.

In fact, the exemptions utilized by Sungy allow the company to go for wellover a year after receiving its money from US investors without even remedying the deficiencies in internal controls. As a result, investors have very little assurance about where the money inside Sungy is going or how the company’s assets are being deployed in this company.

These deficiencies are all the more concerning for an unusual structure like Sungy where investors have no claim on the underlying assets and virtually no voting power.

The biggest risk investors will face is when additional disclosure must be released within Sungy’s first annual 20F filing as a public company, to be released within a few weeks.

Recent indications point to a precipitous decline

But the second reason that Sungy rushed its IPO was perhaps far more important. The offering was launched with perfect timing to coincide with a dramatic spike in revenues and online traffic for its Go Launcher Ex. The fact that the spike coincided with a strong surge in prices for other Chinese Internet stocks made this urgent timing for an immediate IPO even more imperative.

Investors in the IPO somewhat naturally assumed that this growth was natural and sustainable. But independent sources already provide strong indications that this growth was a spike, not a trend. The IPO prospectus included data up until September 2013. But even in the past 6 months, we can already see (shown below) a dramatic decline in 3rd party indicators which should accurately measure traffic and predict revenues.

In recent weeks, additional investors have piled in to Sungy simply because it is a “China Internet Play”. Unfortunately, these investors fail to realize that more than 70% of Sungy’s Go Launcher Ex users are based outside of China. Sungy is NOT a dominant China internet play. Sungy is NOT YY Inc. (YY). Sungy is not Qihoo 360 (QIHU). SUNGY is not Baidu (BIDU).

In fact, even Sungy’s mobile portal (3G.cn), which is predominantly in China, ranks it at just a top 7,000 or lower site in China. (see below).

Yet the mistaken notion of “China Internet Play” is largely responsible for the recent surge in the share price.

Investors should take note that even the investment bankers on the Sungy IPO (JP Morgan and Credit Suisse) maintain share price targets of just $17 and $24 (both issued in 2014). Yet the share price has recently surged to as high as $28 – as much as 50% above where its own optimistic bankers suggest it belongs. Even at the price of $17, JP Morgan rates Sungy a polite “Neutral”.

Sungy’s product offering

Sungy Mobile is a provider of mobile Internet applications, with an emphasis on its Go Launcher Ex and “mobile reading services”. Go Launcher Ex is a “launcher” for android based phones, which means that it is the first software that the android phone sees upon start up. It is the software that “manages apps, widgets and functions on Android smartphones”

The default launcher that comes with an Android phone is typically supplied by Google. After buying the phone, users can then opt to download alternative launchers such as that from Sungy.

Sungy derives its launcher revenues partially from paid downloads, but also largely from advertising spending (as would be expected).

The “mobile reading services” is comprised of an expanding library of original and copyrighted literary works. Readers are charged a fee to access these materials.

A third source of revenue is the mobile portal 3G.cn in China.

An initiation report from Credit Suisse showed the following revenue breakdown.

(click to enlarge)

In preparation for the IPO, Sungy commissioned (ie. paid for) a report by App Annie. The report yielded the following conclusions below. It is these conclusions which are largely responsible for the strong share price performance upon the IPO.

But investors need to remember that these conclusions were based on a snapshot in time as of September 2013. Because Sungy is a new ADR with limited reporting requirements, there has been no update by Sungy to these metrics since that time.

The conclusions from the IPO prospectus were as follows:

- Sungy was one of the top publishers world wide on Google Apps (in the “Applications” category).

- Go Launcher Ex was number one in the “Personalization” category

- As of October, Sungy had 3 out of 44 of the products with more than 50 million cumulative downloads on Google Play (but this is for “non game downloads” only, as games are much more popular)

- Go Launcher Ex has attracted approximately 239 million users, with over 70% of them being outside of China

- In Q3, average monthly “active” users reached 42 million

Indeed, these metrics make Sungy look fantastic. But in reality the Go Launcher Ex is just a fairly simple customization app for an android phone. The prospectus describes it as follows:

GO Launcher EX offers extensive functions and high performance that turn the use of smartphones into a more productive experience. In addition, through themes, widgets and various levels of customization, GO Launcher EX users can extensively personalize their smartphones and change the otherwise monotonous phones into exciting and sensible instruments that perform more in sync with their owners’ habits andsymbolize the individuality of their owners

Updates since the time of the IPO

According to the JP Morgan initiation report, Go Launcher Ex is the only one of the launcher products which has achieved over 1 million paid downloads. It scored a 4.5 on Google Play and had 1.3 million paid downloads as of the time of the JP report in January.

But a better leading indicator is to look at Google Trends.

(click to enlarge)

(click to enlarge)

The above screen shots can be replicated by going to Google Trends and entering the search terms “android launcher” and “Go Launcher Ex” as shown above.

These screen shots show two things. First, even though downloads peaked in 2013 (according to App Annie), actual searches for Go Launcher Ex peaked in 2012 and have been on a straight line decline since that time. Second, much of the real interest in downloads is coming from places like Myanmar and Bangladesh which are very difficult to monetize. We already know that over 70% of the business is coming from outside of China. But we can also see that the interest in Go Launcher Ex is largely coming from markets which are well away from the desirable US and European markets as well.

This is most likely the reason why Sungy did not bother to include a geographic breakdown of its users in the IPO prospectus.

It should be noted that GDP per capita in these countries sits at around $1,000-2,000 per year. They simply do not have the disposable income to either a) pay for downloads or b) attract advertising dollars.

As part of the IPO prospectus, it included a table showing market stats on mobile ad spending. (Note these are NOT stats for Sungy, they are stats for the market).

The table states the obvious: North America, Europe and Japan comprise the overwhelming majority of mobile ad spending. They are also responsible for the largest amount of nominal growth.

What does App Annie say now ?

The IPO prospectus relied heavily upon the commissioned one-time report from App Annie. But a closer look at subsequent developments reveals that App Annie data itself (as reflected in Google Play) is showing a peak and subsequent decline in downloads of Go Launcher Ex. Naturally we should not expect this type of negative data to have been included in a commissioned (ie. paid for) report as part of an IPO prospectus.

(click to enlarge)

The scale of the chart above (from 0-500) tends to understate the size of the declines in downloads. But by looking closer, one can see that Go Launcher Ex was largely a roughly top 50 product just a year ago (as was indicated in the IPO prospectus) but it has now fallen to being largely a top 100-200 app (with the exception of South Korea). The impact between a top 50 and a top 200 is typically exponential, not linear, such that the effect on subsequent revenues from paid downloads and ad spending will by necessity by dramatic. This will likely become clear in Sungy’s first 20F filing as a public company which will be released in a few weeks.

Trends with the mobile portal 3G.cn

The drop off in popularity for the Go Launcher Ex is largely mirrored by a similar drop off in recent months for the 3G.cn portal in China.

Detailed web statistics can be found for 3G.cn by searching at Alexa.com. As expected, the vast majority of traffic comes to this site from within China.

(click to enlarge)

But more importantly, we can see what has happened to traffic at 3G.cn since the IPO just 3 months ago. Fortunately, Alexa provides stats which happen to coincide with this 3 month period.

(click to enlarge)

As shown in the graphic above, at the time of its IPO Sungy’s 3G.cn happened to be a top 50,000 global website. But within just 3 months, this has slipped to top 75,000.

For those who (for some reason) seem to compare Sungy’s 3G.cn to Baidu, Sina or Qihoo, it can be easily seen that within China there are already more than 7,000 website which rank higher than Sungy’s 3G.cn in China.


Sungy’s IPO makes it a troubling investment in two different respects. First, the security which investors buy is strongly disadvantaged. It has almost no voting power due to the deliberate dual class share structure. It also has no claim on the underlying assets of the operating company due to the VIE structure. The company founders and insiders still run the operating assets, despite the conflict of interest that this creates vis a vis the public shareholders. In addition, Sungy made use of an inappropriate JOBS Act exemption to come public in the US despite having multiple serious internal control deficiencies.

The second issue is that these abuses give us a strong indication about management’s attitude towards how it will treat its outside shareholders. This includes how they timed the IPO.

The company rushed to come public at just the time when its business metrics were peaking. Investors must keep in mind that the primary product being offered by Sungy is simply an app which allows one to customize things like icons and wallpaper on one’s cell phone.

Independent metrics now show that most areas of Sungy’s business are now showing sharp declines in interest rather than continued surging growth. This is very typical for “one hit wonder” app and game developers.

What is less typical is when a company is able to rush out such a disadvantaged security to investors just as its metrics are peaking and at just the right time when all of the sector comps are hitting all time highs.

Given the aggressive structure that was sold to investors and the newly declining metrics, Sungy should be expected to trade back down to around its IPO price of $11.22 (eventually even lower). The reasons for this will become clear as soon as the company’s first 20F is released in the next few weeks. The aggressive nature of the IPO should also be expected to signal heavy potential selling upon the upcoming expiration of the IPO lockup.

Note: prior to publication, the author did speak with Sungy’s IR rep. The company currently says it is in a quiet period ahead of earnings and is not responding to requests for information. The earnings date has not yet been announced.


Author’s Disclosure: 

Based on the above, the author is short GOMO.

MiMedx set to fall further

5040933710_9e93149223_b copy

My last short article discussed Farmer Brothers Coffee (FARM) and since that time, the stock has come off by nearly 20% without much of a bounce. Prior to that, I discussed Unilife (UNIS), which is now down by 15-20% for largely the reasons I predicted. Before that, I highlighted unacknowledged and low-priced product competition for Organovo Holdings (ONVO). At the time, the stock had been trading around $13.00, and now it has fallen to $9.00. Prior to that, my earnings call on Ignite Restaurant Group (IRG) correctly predicted a fall of around 30% in that stock.

But for today, I am focused on an even better near-term short opportunity in MiMedx Group (MDXG).

MiMedx – Investment thesis

Shares of MiMedx are likely to see a decline of 30-40% in the near term. The stock represents an ideal short candidate due to its tremendous free float of nearly 100 million shares combined with a negligible short interest of just 5.8 million shares. There are also liquid options which trade on the stock.Institutional ownership is negligible and the CEO is the only insider with any meaningful ownership of stock.

Yet, these are not the real problems. The real reasons for the sell thesis are as follows:

1. A deeply flawed FDA clinical “study” which was irreparably skewed, providing stellar (but arguably misleading) results for the EpiFix product

2. Heavy marketing of that same study (by MiMedx and its banker/analysts) despite superior trials by competing products

3. A complete mis-presentation of the implications of recent Medicare reimbursement changes

4. Substantial changes in the competitive landscape for skin substitute products

5. Heavy selling by CEO Pete Petit (the largest shareholder) of over $1.2 million

6. Indications that the largest outside shareholder ADEC is liquidating (just sold below the stealth non-disclosure point of 4.99%)

7. The onset of analyst downgrades, with Northland seeing around 20% declines from current levels

This report is divided into three sections.

SECTION ONE - Background information provides detailed background information on the evolving situation at MiMedx, along with several reasons NOT to sell the stock. Presenting this information first will allow readers to better evaluate the real risks and the reasons why MiMedx is likely to be facing steep declines in the near future.

SECTION TWO – the red flags illustrates that there are more than ample warning signs which should presage the upcoming declines. The upcoming declines should come as no surprise to anyone.

SECTION THREE – the black swans details the much deeper negative catalyst events – which the mostly retail investor base has almost entirely ignored. Section three is clearly the most important part of this article. So for those who wish to “skip to the point” – section three contains the most price-relevant details.

SECTION ONE: Background information

With over 100 million shares outstanding, MiMedx currently has a market cap of nearly $800 million. Yet, with nearly 20 million additional (deep in the money) warrants and options outstanding, this market cap swells to over $1 billion. Many of these options have strike prices well below $1.00 and are set to expire in 2014, implying substantial near-term dilution.

MiMedx generated $40 million in sales over the first 9 months of 2013, resulting in a net loss of $2.7 million. The company has never generated a profit. The share price has recently been trading in the $7-8 range and the company currently has just 40 cents per share in cash (following a $39 million capital raise in December).

MiMedx Products

MiMedx Group describes itself as “an integrated developer, manufacturer and marketer of regenerative biomaterial products processed http://vinegarhillhouse.com/generic/ from human amniotic membrane.” What the company does is to collect donated human placentas from hospitals via C-Section births. These placentas would otherwise be discarded as medical waste. MiMedx then uses/processes these placentas into a type of healing application for burns and wounds.

The company’s two main products are EpiFix and AmnioFix. EpiFix can basically be viewed as an enhanced skin patch for use on external burns, wounds and ulcers. AmnioFix serves a similar function but is for internal use in sports medicine and surgeries, including spinals and tennis elbow.

On October 1st, the company announced that it had signed a distribution agreement with Medtronic to provide its allografts for distribution via Medtronic’s SpinalGraft Technologies (“SGT”) subsidiary. Terms were not disclosed.

These products are not FDA-approved via clinical trials, but instead have been governed under HCT/P regulations (“Human Cells, Tissues, and Cellular and Tissue-Based Products”) which allow marketing of products which have been minimally manipulated (among other criteria). These products are regulated under Section 361 of the PHS Act.

MiMedx Share Price Performance

Over the past two years, share price performance at MiMedx has been stellar. At their recent peak, the shares had risen from just over a $1.00 to just shy of $9.00. However, there is a very high likelihood of a 30-40% decline in MiMedx in the near future, to a price of around $4-5. Yet, the market has almost entirely missed the real reasons why.

(click to enlarge)

Two possible “red herrings” – NOT the reasons to sell

Again, for clarity, the following two issues are quite well-known and have been absorbed by the market. They are just presented for completeness.

During the end of 2013, a number of headline concerns caused the stock to exhibit substantial volatility. In September, panic over an FDA “untitled letter” following an inspection at the company’s Marietta, Georgia plant sent the stock plunging to as low as $1.81 in intra-day trading and the stock was halted several times during the day. The FDA letter stated the MiMedx had violated the Public Health Service Act by improperly manufacturing and marketing drugs that are also a biological product, but without a valid biologics license. The good news is that the products (currently) in question only comprise 15% of MiMedx’s revenues. The bad news is twofold: First, the company will now likely have to pursue an expensive FDA approval process and obtain a BLA. Second, even a minor hit to the financials may have a disproportionate impact on the share price due to the extremely high price-to-sales multiple and the historical lack of profitability.

So far, MiMedx has said that it does not agree with the FDA and is currently in discussions on how to proceed. For the time being, this issue has been digested by the market and does not appear to be a primary concern for investors.

A separate issue is the SEC investigation of potential insider trading violations by CEO Pete Petit in connection with information allegedly shared regarding his company Matria Healthcare prior to the sale of that company. The headline in the Atlanta Business Chronicle was short and scary, noting that “SEC Sues Pete Petit, Alleges Fraud“.

But the reality is that despite any previous violations, this investigation is unlikely to impact the specific financials at MiMedx. The downside scenario would be limited to the potential loss of Mr. Petit’s management involvement if he were forced to step down, and some possible pressure on the share price simply due to more negative headlines. As with the FDA impact above, this issue is not a primary reason to sell the stock, but the impact could be disproportionately large simply due to the very lofty multiple upon which MiMedx trades.

SECTION TWO: The red flags and warnings

One major problem at MiMedx is that as these (mostly retail) investors have gotten comfortable (desensitized) with the scary headlines, they have also overlooked a number of very real problems.

In November and December, MiMedx released a series of very bullish press releases which helped to bolster the stock. These items were then amplified by sell-side analysts (who happen to be the investment bankers for MiMedx).

(click to enlarge)

The share price continued to skyrocket on the back of their analysis and steep price upgrades. Within the space of a few weeks, Canaccord repeatedly boosted their target on the stock. In early November, when the stock was in the $5s, Canaccord told us it was a $6.50 stock. But as the much anticipated equity offering drew nearer, Canaccord nearly doubled the target to $12.00 in December. The basis for such a dramatic hike seems unclear. This increase implies an increase in market cap of nearly $600 million for MiMedx even though Canaccord only increased its 2014 revenue estimates for MiMedx by a mere $27 million. But as would be expected, the share price soared as shown above.

Not surprisingly, Canaccord was appointed bookrunner on MiMedx’s $39 million equity offering in December. Canaccord reaped millions in fees. Small cap investment bank Craig Hallum only had a $9 target on the stock, so they were only awarded joint lead status on the offering, making perhaps under $1 million in fees. But certainly, their $9.00 target did imply a 50% rise in the share price vs. its then prevailing level of around $6.00.

But wait. It gets better.

Shortly after the company sold $39 million in stock, CEO Pete Petit sold over$1.2 million in stock from his personal holdings. MiMedx’s largest shareholder (ADEC Private Equity) then reduced their holding to just below 4.99% of the company – allowing further sales (including a complete liquidation) to go without any need to report the sales. This is a very standard “stealth liquidation” technique.

And just as all of this was happening, we started to get the first analyst downgrades on the stock from Northland Securities with a $6.00 target. It should come as no surprise to anyone that the only bank to have the guts to downgrade the stock is the one who wasn’t being paid investment banking fees.

Despite the lofty targets from the research analysts (a.k.a. bankers), the company, the management and the largest holder were all suddenly eager to sell. But why?

From the Northland report:

Key Points

  • Our downgrade is a valuation callIrrespective of how Q4 numbers shape up or how aggressive fiscal 2014 guidance is provided, we cannot reconcile current valuation with the ground fundamentals.
  • In our opinion, we are entering a vicious cycle of CMS constantly squeezing out the marginal dollar from skin substitute reimbursement. For Mimedx, the current payment levels for Q-code reimbursement for EpiFix are “temporary” in nature. Once bundled rates come into effect, the playing field will be leveled. While EpiFix has favorable MAC coverage policies, that seems to be baked into the stock.
  •  However, our general impression of the tissue space has always been that most products are undifferentiated and suffer from a lack of rigorous randomized trials. Hence, aggressive marketing plays a stronger role than true clinical advantages or disadvantages….

At the bottom of this report, I will illustrate the transparent flaws in the research reports provided by the other (and far more bullish) sell side analysts who have provided investment banking services to MiMedx.

SECTION THREE: The black swans

Clearly, there are several issues which at one time spooked the investors in MiMedx, quickly sending the stock to as low as $1.81 in intraday trading. But even with the various warning signs that have been presented above, investors are continuing to award MiMedx a market cap of nearly $800 million to $1 billion.

The issues presented here in Section Three are the real issues which could well see the stock decline by 30-40%. It appears that very few investors are aware of these issues. Again, MiMedx is a stock which has minimal institutional holdings. The largest institution reduced its stake below 4.99% in January, such that we do not know if they still are even holding any shares.

A deeply flawed clinical “study”

The details behind MiMedx’s recently published “clinical study” are far more dangerous to the company’s near-term future than are the FDA letter or the insider trading investigation.

In 2013, the International Wound Journal published a study entitled “A prospective randomised comparative parallel study of amniotic membrane wound graft in the management of diabetic foot ulcers“. This study had been initiated on the FDA’s ClinicalTrials.gov in 2012 and was sponsored by MiMedx.

The purpose of the sponsored study was to see how EpiFix (an amniotic membrane wound graft) compared to “standard of care” in treating Diabetic Foot Ulcers. These ulcers often affect the feet of obese diabetic patients. Healing can be impacted by factors such as age, weight (i.e. pressure on the wound) as well as the size of the wound.

The study concluded that


Patients treated with EpiFix achieved superior healing rates over standard treatment alone. These results show that using EpiFix in addition to standard care is efficacious for wound healing.


It also cited an overall healing rate of 92% at 6 weeks.

Not surprisingly, the truly spectacular results from this sponsored studyhave been widely repeated and quoted by sell-side analysts/bankers (to investors) and by management (presumably to doctors and prospective patients).

For example, Lake Street Capital quotes this study and management saying (almost verbatim)


EpiFix, the company’s lead product, heals diabetic foot ulcers (DFUs)twice as fast and three times better than competing alternatives at a lower cost,


Clearly, Lake Street didn’t bother to read the fine print contained within the study, or they may have expressed less of such unbridled optimism.

As part of the journal article, there was included a table which illustrated the demographic details of the clinical study for EpiFix. This table is reproduced in identical form as follows:

(click to enlarge)

Anyone who understands clinical trial design (or even just plain statistics) is likely now hitting the “sell” button on MiMedx before reading any further.

The implications of this table should be quite obvious.

On average, patients in the EpiFix trial group were 5 years younger. Their wounds were 25% smaller. Their body mass (i.e. obesity) was around 15% less.

In fact, as shown in the table above, the deviations from the mean are even more significant than the means. With EpiFix, the youngest patient was 15 years younger than in the SOC group. The lowest body mass was 20% lower. The SOC group had a maximum wound size that was 20% larger than for the EpiFix group.

With such a skewed patient population, it would have been truly stunning if the EpiFix trial did not produce a spectacular improvement vs. “standard of care” in the older and fatter people with larger wounds.

It should also be noted that much more reliable results could have been obtained with a proper trial. The original trial was slated to encompass 80 patients. This is already quite small, but ultimately the study only included 25 patients, with a mere 13 patients treated with EpiFix grafts. They then compared the results to a mere 12 patients who happened to be older, fatter and had larger wounds.

The point is that as studies go, this one should not be viewed as being even remotely conclusive. It delivered results that should have been 100% expected – and in a population size that was too small to even matter.

What investors need to understand is this:

As noted above, these amnio products are treated as HCT/P products and as such do not require clinical trials. So what was the point of this study if it was not to pursue a clinical trial? The trial design was so faulty that it clearly would not have passed muster if it were to eventually be used for legitimate clinical trials.

Clearly, it served more of a marketing purpose than a regulatory purpose. The study and a follow-up has been published and has then been subsequently publicized by MiMedx. In November, MiMedx stated that


A competitor recently announced that the clinical study of their products showed that only 52% of their patients both healed in 12 weeks and remained healed at the subsequent 12 week follow-up. An optimal treatment for DFU would be one that supports both rapid and long-term healing. With 94.4% of DFUs remaining healed approximately one year after treatment, we believe our EpiFix® allograft is a clinically effective and economic solution to these needs.


In January, skin substitute competitor Organogenesis (maker of Alpigraf)announced that it had acquired the other major competing product (Dermagraft) from Shire Pharmaceuticals. Together, these two products dominate the market for skin substitutes.

So how do their products compare in terms of clinical data ?

For Dermagraft, we can see the that the pivotal study was far larger and more rigorous. It involved 314 patients in multiple centers (as opposed to the 25 patients in one center for EpiFix).

The study also noted that


If the study ulcer had not decreased in size by more than 50% during the next 2 weeks and the patient met all other inclusion and exclusion criteria, the patient was randomized into the study.


In other words, this competing study took the approach of only attemptingto test on patients who had very persistent and resistant diabetic foot ulcers. They deliberately selected the most challenging patients in an attempt to genuinely see if the treatment would provide a meaningful benefit. This is as opposed to trying to find the patients who would quite obviously be healed as quickly as possible. The result is that the blatant “marketing benefit” is naturally less spectacular.

Likewise, the study for Apligraf included 208 patients, and it is noted that it deliberately “excluded patients who exhibited rapid healing“.

MiMedx management has repeatedly made reference to the “published studies” which tout its product. Yet, it should be clear from the demographics of the 13 patients who were treated in a single site that these studies possess predictable marketing value to a much greater extent than they do scientific rigor.

One might wonder what sort of doctor/scientist would put his name on such a tiny and skewed study. The name of the lead author was Charles Zelen, and it turns out that he was the lead author on three of the six “clinical publications” that are listed on MiMedx’s website. The other three were co-authored by Donald E. Fetterolf, who happens to be chief medical officer at MiMedx. These six studies are the only “clinical publications” listed on the MiMedx website.

The point is that it is very easy to write a “study” and submit it to a specialized journal such as the “International Wound Journal” or the “Journal of Wound Care”. The study will, of course, be published. And then companies such as MiMedx get to make simple statements touting their publication in these journals. It is easy and guaranteed marketing material, even when it lacks the scientific rigor of legitimate FDA trials.

Why should investors care?

The reason to care is that the FDA has already demonstrated that it is cracking down substantially on inappropriate marketing and other practices by those in the skin substitute market. We saw this with the FDA untitled letter for MiMedx in September. But (not by coincidence) we saw the same thing at Osiris (OSIR) for its own skin substitute. An FDA untitled letter was issued to Osiris in October, just one month after MiMedx.

Investors can decide for themselves if the claims being made by MiMedx are well-substantiated given the tiny trial size and the skewed demographics of the participants. They can also decide for themselves what will be the impact of any decision by the FDA to require more rigorous and perhaps fully formal trials.

Understanding the new world of Medicare reimbursement

On November 29th, MiMedx put out a press release to announce that “the Company applauds the Centers for Medicare and Medicaid Services’ (CMS) new methodology for the reimbursement of skin substitutes” which had been released two days earlier.

There are really only two components of the CMS announcement that need to be understood.

The first component is the fact that for the remainder of 2014, EpiFix will retain its Pass Through Status for its third and final year. In effect, the new reimbursement policies will not affect reimbursement at all for the duration of 2014. EpiFix already had Pass Through Status for the past two years, and three years is the maximum allowable. This continuation is indeed moderately favorable for EpiFix, but the duration of only 1 year means that its impact will naturally be limited. But the market has basically priced in the scenario that MiMedx is going to have a permanent cost and reimbursement advantage over its competitors. This has led to inflated expectations for revenues.

In addition, MiMedx was not the only one to receive Pass Through Status. The market seems to have ignored this as well. Osiris was actually granted an additional two years of Pass Through Status, even though its product is widely regarded as among the most inferior of the products on the market. (One key takeaway from this observation is that Pass Through Status is basically being awarded to products that are simply “new” as opposed to being actually “better”.)

The second component is more complicated – and more important. CMS will now be introducing a two-tiered reimbursement system, which will dramatically alter the competitive landscape.

Anyone who is contemplating a long or short investment in MiMedx needs to understand the full details of this new policy adjustment. The text of the November 27th announcement can be found here at the CMS.gov newsroom and the fuller versions here.

Under the “old” system, reimbursement was calculated as average selling price (“ASP”) +6%. Under the “new” system, reimbursement will be split among two types: high cost and low cost.

The old system of ASP+6% basically incentivized the market leaders (such as Shire and Organogenesis) to manufacture one-size-fits-all sheets of skin substitute. As a result, they produced sheets in standardized sizes (ie. cheaper to manufacture) and in sizes that were too big (i.e. reimbursed at cost plus, so maximizing revenues). The predictable result was massive amounts of waste when 40 sq cm of standardized substitute had to be purchased just to treat a wound that was 2-3 sq cm in size.

Many may find it galling to know that such a system of perverse incentives was in place and running. These manufacturers were clearly incentivized to only produce their products in a size that guaranteed substantial overcharging and waste. But we should also be happy that the once-flawed system has been analyzed and tweaked to reduce product waste and economic waste. At least the supervisory feedback function has had the desired effect.

Under the new system, “high-cost products” are those with an ASP of $32/sq cm or higher. These will be reimbursed at $1,371.19 for up to 100 sq cm of product. Wounds over 100 sq cm will be reimbursed at a maximum rate of $2,260.

“Low-cost products” are those with an ASP below $32 per sq cm. They will be reimbursed at a rate of up to a maximum of $409.41 per 100 sq cm of product.

Understanding the competitive response to the CMS changes

Just after the CMS announcement (and – of course – just prior to the equity offering), small cap investment bank Craig Hallum put out a “quick note” to explain the implications of these massive changes on MiMedx. The note was just one-page long and noted the following:


The two market leading products, Apligraf® and Dermagraft®, are not offered in a size-appropriate graft which is the chief reason for $100M in annual wastage prompting this decision by CMS. Prior to this new regulation, all reimbursement was set at ASP +6% which is why the competition was able to establish market share in the first place.

While the final rule paints a slightly better picture for MDXG’s competitors, they will still have to cut prices substantially or file PMA supplements in order to remain a competitive force in the years ahead. With this new rule, we believe MDXG could garner an incremental $50M in revenues over the next several years as the Company establishes a dominant position in the wound care marketplace.


This justification was used to state a $9.00 target (50% above the prevailing price at the time).

Basically, what Hallum is saying is that the competitors will simply to continue to offer wrong-sized products at non-competitive prices despite new and different incentives to offer smaller products at rational prices. Ergo: the Craig Hallum banking client should be expected to rise by 50% (just in time for the company to raise $39 million in an equity offering).

This assumption is pure and unadulterated nonsense, and we will soon see that it will not play out in reality. It was nothing more than an excuse to justify a high share price target ahead of an equity offering in which Hallum hoped to be well-paid. The competitors will certainly change their product offerings in order to provide an economically rational (i.e. size-appropriate) product which will be reimbursed at proper rates accordingly.

Craig Hallum does include a minor mention of these competitors who would enjoy a “slightly better picture” in its one-page report. But it notes that “Dermagraft” by Shire and “Apligraft” by Organogenesis are nearly 2-3x as expensive as EpiFix, while they are to be reimbursed at the same rate.

Craig Hallum ultimately was selected as a lead manager on the equity offering alongside bookrunner Canacord and pulled in substantial fees a few weeks later, just as the share price was soaring on the back of upgrades like this.

Looking at past examples – history is repeating itself

Readers who have followed my articles over the past year may remember that I have repeatedly called out similar research nonsense from Craig Hallum during 2013. Each of my articles said the same exact thing: over-bullish research calls were preceding investment banking deals by Hallum clients. The stocks soared, the equity was issued. Craig Hallum got paid their fees. Then the stocks tumbled.

Past Hallum examples (which I wrote about) included TearLab (TEAR), Neonode (NEON) and Uni-Pixel (UNXL). Readers will also remember that I was proven right about each one of these stocks within either a few days or a few weeks at most.

From the time I wrote about each of these Hallum stocks, each is now down by at least 20-30% – despite predictions of double-triple digit gains by Craig Hallum.

In each case, these Hallum bull calls came just in time for Hallum to help them issue stock. Hallum made millions in total fees. In each case, the bullish predictions came unraveled not long after the equity offering was completed.

Following the equity offerings, these banks tend to provide a few weeks of bullish support for their banking clients, helping to support the stock. If they did not do so, they would certainly aggravate their hedge fund clients who bought into the deals.

But we can see that reality is typically quick to set in, and the share price cannot sustain itself forever once real revenues fail to materialize as predicted in the bullish (pre-financing) research reports.

Perhaps a few examples would help to illustrate.

Prior to recent earnings, Hallum had an $18 target on TearLab. As with MiMedx, this was apparently based on the supposedly stellar growth prospects. What about Canaccord? Canaccord had a $19 target. Even though the growth prospects were challenged and the valuation was already excessive, TearLab’s investment bankers, by coincidence Hallum and Canaccord, raised $35 million for TearLab, making several million in fees. The offering price was $13.50. Since that time, insiders have been steady sellersof shares at prices around 40-50% below the banker targets.

On November 8th, I published an article entitled “Earnings Miss Will Send TearLab Sharply Lower“, which showed that my own research (including phone calls to dozens of eye doctors who were supposedly TearLab customers) indicated a very high likelihood of


a share price decline of at least 25% to around $8.50 or below.


The share price had been sitting at around $11.00 at the time and the earnings were (as expected) the catalyst for a quick and sustained sell-off. Shares of TearLab now trade for around $6-7 – down by around 40% since my report, but around 66% below the targets put forth by Hallum and Cannacord, which still sit at $18-19.

On Uni-Pixel, I also called out the Craig Hallum client as being the subject ofirrational and unsubstantiated promotion. At the time, the share price was around $15. As with MiMedx (and TearLab), Hallum repeatedly raised their share price targets on Uni-Pixel (ultimately to $58, up from a share price of $10). This caused the share price to trade to over $40. Of course, this was just in time for Uni-Pixel to complete an equity offering of over $30 million with Craig Hallum an investment banker. Then, of course, the company failed to live up to the sky-high projections put forth in the (pre-financing) Hallum research. After the equity offering was complete, the stock quickly began to plunge and now sits at around $9.00. Hallum has since (i.e. after collecting its investment banking fees) reduced its price target on Uni-Pixel to just $9.00 from $58.00 – certainly a significant (post-investment banking) target revision.

But wait… I’m not done.

In September, I published a warning about Hallum client Neonode . Despite losing the majority of its revenues and its largest client, Hallum saw fit to upgrade $5.00 Neonode to a $10.00 target price. The stock soared (even though Neonode had just delivered a painful earnings miss). What followed was quite predictable. A Craig Hallum-led equity offering in which management were the largest sellers. As with MiMedx, Neonode management was very eager to sell their personal holdings at current prices even though Craig Hallum was telling outside investors that the stock will continue to soar by double-digit percentages. When I wrote about Neonode, the stock had been sitting at around $7.50. The stock since fallen to around $5.50-5.70 (a decline of around 25% – and a shortfall of 50% vs. the latest Craig Hallum target.)

But let’s not forget about Canaccord’s involvement here.

As we look at the ratings on MiMedx by Canaccord and Hallum, we can see that Canaccord started at $6.00 in October but doubled this to $12 by December, the month of the equity offering. Hallum started in March at $7.00 and then raised to $9.00.

The charts tell the story best. Here are the charts of the research-driven run-ups before the predictable equity offerings. The charts also show thepredictable plunges once the hyper-optimism for these high-priced “growth stocks” fails to result in concrete results.

(click to enlarge)

The pattern, for those who might have missed it, is that a money-losing company (who happens to need to raise money) is bestowed with a series of sky-high share price targets. When the share price rises, the target is simply raised higher.

Then the company issues a large amount of stock (paying its banker/research provider millions in fees).

The stock is typically strong for a while, which is clearly good for the hedge fund clients who bought the deal.

But then when the excessive optimism fails to translate into reality, the hedge funds disappear and the stock inevitably falls back to where it began.

Readers should please keep in mind that the examples above were not cherry-picked for the convenience of this article. These examples were given because they were all stocks which I wrote about in 2013 and where I warned about this exact sequence of events well before they materialized.

MiMedx is the exact same example. There are overly bullish forecasts being put forth despite commonsense evidence to the contrary which is patently obvious. Now that MiMedx has already raised its $39 million in proceeds, and now that the CEO and the largest outside shareholder have begun selling stock, there is every reason to expect substantially more downside to come in the next few weeks.

Conclusion – what is MiMedx worth?

As with TearLab, Neonode and Uni-Pixel (among others), MiMedx has achieved a spectacular valuation of 10-20x sales based on hyper-bullish projections for future growth which will supposedly be driven by some tremendous recent catalysts.

But the analysts providing these numbers also happen to be the investment bankers to the company and stand to make millions in fees if the company selects them to underwrite the offerings.

By contrast, investment banks (as well as research analysts) have no method of monetizing any level of accuracy in their stock picks.

These analysts have blatantly ignored the flaws in MiMedx’s “clinical study” and have turned a blind eye toward the very obvious competitive reaction that will occur following CMS reimbursement changes.

These same banks were among the ones who made identical leaps of faith in projecting triple-digit rises in the shares of TearLab, Neonode and Uni-Pixel (among many others).

Best-case scenario is that MiMedx continues to execute and that the valuation finds a sustainable level. This probably puts MiMedx at around $4-5.

But worst-case scenario is that there is fallout from the FDA in terms of regulating one or more products and that the competitive response from the well-funded competitors is in line with what should be expected.

If this is the case, then MiMedx will not be profitable at any time in the near future and the share price is more likely to stabilize at around $3.00.


Disclosure:  The author is short MDXG

Trouble Brewing at Farmer Bros Coffee (FARM)

spilled coffee


Farmer Brothers coffee (FARM) was founded in 1912 by Roy E Farmer. The company is headquartered in Torrance, CA, which location also serves as a manufacturing and distribution hub.

The company became publicly traded in 1951 and for a while was profitable and paid a dividend. Yet the company has now failed to generate any annual profit since 2007. In 2011, the company cancelled its dividend, citing ongoing financial circumstances.

The company is not widely covered on the research side, while much of the institutional holdings consist of passive index funds. As a result, the share price has gradually crept up from a low of around $7 in 2012 to over $24 by late 2013. Much is this has been due to strong performance by other stocks in the coffee space such as Starbucks (SBUX) and Green Mountain Coffee (GMCR).

Farmer Brothers typically trades up gradually on very light volume and there have been almost no large, event-driven moves in it. There is virtually no short interest in the stock, with only 1-2% of the float being sold short. The market cap is currently just over $300 million.

The company has occasionally reported individual quarters of profitability. But as we saw last year, this was driven by one time gains, such as sales of real estate, and not due to sales of coffee.

This gradual rise in the share price has occurred despite a mounting series of problems at Farmer Brothers, including the following:

  • recent forced restatement of 3 years of erroneous financials
  • disclosure of a material weakness in internal controls
  • significant speculation in coffee derivatives leading to large and consistent losses
  • resignations from key members of the finance team
  • an unfunded pension liability of $40 million
  • short sighted financial practices such as “self insuring” to minimize near term insurance expenses
  • inventory accounting which maximizes reported profit but which conflicts with the actual flow of goods
  • significant involvement and influence from late generation members of Farmer family despite little to no business experience
  • virtually no share ownership by any members of management

Key catalyst for a sharp decline at Farmer Brothers

The year 2013 saw two significant resignations from the finance team at Farmer Brothers. Also in 2013, the company was forced to restate 3 years of financials due to improper accounting for its very large pension obligations. The financials had all been previously signed off on by auditor E&Y as well as by management.

On December 30th, 2013, Farmer Brothers announced that it would be switching auditors from E&Y to Deloitte. The immediate impact of this announcement was largely muted due to the fact that it was released after the close of markets on the night before New Years Eve, along with the fact that the stock is not widely covered.

This new switch creates a tremendous risk that a new auditor will reevaluate current and past accounting treatment for items which may be considered aggressive and murky (including pension and derivative accounting) and will therefore require another (and potentially larger) financial restatement. Additional items such as the debatable use of LIFO accounting (which helps the company boost gross margins) should be more clear cut in the eyes of a new auditor. As most investors know, the use of LIFO in an environment of falling prices will always boost margins. Yet companies who sell perishable goods must always sell these goods as close to First In First Out in order to avoid unnecessary spoilage. In any event, this treatment is not consistent with major competitors. This will be demonstrated below.

Any time that a firm with a history of financial troubles and aggressive accounting switches auditors, it should be considered a greatly heightened risk factor for the share price. Initial audits by new auditors are generally considered to be the most thorough and stringent. The items detailed below should be evaluated in the context of how they will be viewed upon an initial audit by new auditor Deloitte.

Overview of financial concerns

Each of the concerns shown above is explained in detail below. However, the big picture can be summarized as follows:

It has now been an ongoing problem for years that the true net income (loss) being experienced at Farmer Brothers is more substantially influenced by things like pension and derivative accounting treatment than it is on the actual business of selling coffee itself.

Much of this has been missed by the very passive investor base because the impact of these items on Farmer Brothers is taken “below the line”. It is buried in “other comprehensive income” and not treated as a part of the “net income (loss)” line item.

As we will see below, these accounting items significantly outweigh the overall effect of what Farmer Brothers is supposed to be doing – ie. simply selling coffee.

Forced restatement of 3 years of financials

On September 11th, 2013, Farmer Brothers announced that its past 3 years of financials should no longer be relied upon due to significant errors in is reporting for post retirement benefits. Farmer Brothers has been in business for over 100 years and continues to employ nearly 2,000 people, such that its pension obligations are meaningful, standing at over $130 million.

As part of the restatement it was forced to disclose a material weakness in its internal controls. It was also disclosed that there were certain additional errors found in its reporting, but they deemed that these errors were “immaterial”.

It should be noted that auditor E&Y had previously signed off on all of these erroneous financials. Investors now have adequate reason to be concerned that a fresh look by Deloitte will uncover additional items that had slipped by under the watch of E&Y for whatever reason.

The items which had been determined by management and E&Y to be “immaterial” could certainly be considered to be quite “material” for anyone who owns stock in Farmer Brothers. The Net Income (Loss) was restated by as much as $3 million, Liabilities were off by as much as $13 million, Total Comprehensive Loss was off by as much as $9 million, while Total Equity was off by as much as $15 million.

These amounts would certainly appear to be substantial for a company which had a market cap of around $120 million last year. The current market cap has risen to over $300 million.

The notice of this restatement came at the very last minute for Farmer Brothers, with just 2 days left before it was required to file its 10K in September. As a result, the company filed Form12b-25 to get an extra 15 days to file its 10K.

As that date rolled around, the company missed the new deadline once again, with the result that it received a NASDAQ delisting notice which triggered events of default with its banks. These were then modified by the lenders subject to remedying of the delisting.

When the 10K was finally released, it revealed that the process of restatement had had significantly negative impacts on the company. The magnitude of these impacts should be read carefully, because they will become highly relevant below.

As disclosed by Farmer Brothers:


We cannot be certain that the measures we have taken since we completed the restatement process will ensure that restatements will not occur in the future. The restatement may affect investor confidence in the accuracy of our financial disclosures, may raise reputational issues for our business and may result in a decline in share price and stockholder lawsuits related to the restatement. The restatement process was resource-intensive and involved a significant amount of internal resources, including attention from management, and significant accounting costs.


We have identified control deficiencies in our financial reporting process that constituted a material weakness in our controls over our accounting for and reporting of other postretirement benefit obligations, leading to the restatement of certain prior period financial statements. Specifically, our controls did not properly identify the failure to apply generally accepted accounting principles with respect to the accounting for death benefits and the related cash surrender value of life insurance, and did not properly detect when changes or amendments to other postretirement benefit plans occurred that should have resulted in changes to the related benefit plan obligations. As a result, material errors to the recorded postretirement benefit liability, postretirement death benefit liability and cash surrender value of life insurance purchased to fund the postretirement death benefit occurred and were not timely detected.

The restatement was obviously a bad thing. It was embarrassing. It was unprofessional. It was expensive. It created a significant drain on internal resources away from managing the business and trying to make money by selling coffee.

But here is the real point of concern:

The delisting notice was received on October 3rd. As a result, most shareholders should be outraged that just 5 days later, the company awarded record bonuses to all members of management, which in each case were in excess of 100% of their target amounts as set in their incentive plans. Again, this was almost immediately after the public disclosure of the significant impact of their erroneous accounting and management decisions.


Officer  Maximum target bonus Actual bonus (2013) %
Michael H. Keown
 $     475,000 536,274 113%
Mark A. Harding(2)
 $     128,250 142,908 111%
Thomas W. Mortensen(2)  $     128,250 142,908 111%
Hortensia R. Gómez  $      60,000 66,029 110%

In addition to the amounts above, CFO Mark Nelson was also paid a bonus of over $36,000 as a partial year bonus even though he had only been employed at the company for a few months prior to the June 30th Fiscal Year end. This was 112% of his target pro rata bonus.

In any ordinary public company, the substantial multi year restatement would have likely been a reason for members of management to feel lucky to keep their jobs and simply receive a zero bonus as a warning. This is particularly true given that 2013 was the 7th consecutive year of net losses for Farmer Brothers. As we saw from the disclosure above, the impact of these restatements was very substantial.

When management consistently fails at their jobs, they are supposed to be sent a strong message to change or else they are replaced.

But at Farmer Brothers, the company continues to receive strong influence from the family descendents of Roy Farmer, who founded the company over 100 years ago. It is not really run much like an independent public company which is supposed to serve the interests of shareholders.

Roy Farmer’s son (also named Roy) had previously served as chairman. His two daughters (Jeanne Farmer Grossman and Carol Farmer Waite) have more recently served on the board of directors. Ms. Farmer-Waite’s son currently holds the somewhat ambiguous title of “Vice President of Coffee” and earns $270,000 per year.

As shown below,these later generation members of the Farmer family have demonstrated no qualifications to run this company. Had they not been born with the last name “Farmer” there is clearly no conceivable way they would be in any position to be managing any public company.

Ms. Farmer-Grossman is Chairman of the Compensation Committee and would therefore have been responsible for setting the record bonuses following the restatement of 3 years of erroneous financials and the NASDAQ delisting notice. She would also be responsible for signing off on the $270,000 compensation awarded to her nephew who serves as “Vice President of Coffee”. Ms. Farmer-Grossman also sits on the Nominations Committee of the board.

In justifying her significant board roles and decision making authority, the latest proxy notes that her experience is as a “retired teacher and homemaker” age 63, who received her undergraduate degree in education. If she has any business experience, none is cited in these credentials. Likewise, her sister Carol Farmer Waite is also a retired school teacher.

In clarifying qualifications, the proxy states that “Ms. Grossman’s qualifications to sit on our Board include her extensive knowledge of the Company‘s culture and sensitivity for Company core values…”

By being born into the Farmer family, and by virtue of owning roughly $20 million in stock, Ms. Farmer-Grossman has been granted a position of authority and responsibility on two board committees. The ongoing management of Farmer Brothers as a family fiefdom by those with zero business experience is what has led to consecutive years of ongoing net losses and cancellation of the dividend as well as a massive and amateurish financial restatement due to poor supervision of the finance team.

In fact, as we will see below, there are much larger problems brewing at Farmer Brothers which have also likely been swept under the rug. Although these have been given scant attention by management and the board, they will certainly be closely evaluated during the first audit by new auditor Deloitte.

Speculation in coffee derivatives leading to large consistent losses

Farmer Brothers frequently refers to its large purchases of coffee derivatives as being for “hedging” purposes. There are several obvious signs that these purchases have more to due with speculative bets on coffee prices than they do with hedging sales of coffee products.

Farmer Brothers should not be in the business of gambling on the direction of commodity markets. Even professional commodities traders find it hard to do well in these volatile markets. Moreover, it is clear that Farmer Brothers has demonstrated a consistent habit of placing bets which are very large and very wrong and which have repeatedly cost the company tens of millions of dollars.

Rather than just running the business, Farmer Brothers has tried to “call the bottom” on coffee prices and has hoped to profit by loading up on large amounts of coffee derivatives. The problem is that the price of coffee has seen a continuing slide for 3 years running and there does not appear to be any end in sight in the near term.

The Wall Street Journal recently ran an article entitled “As Coffee Prices Decline, Investors Brace for More

It noted that:

Coffee prices have tumbled 20% this year, capping the biggest two-year plunge in a decade and highlighting commodity markets’ struggle with a supply deluge.

Coffee prices haven’t fallen for three consecutive years since the early 1990s. Since 2011, coffee prices are down 49%. That is the largest two-year decline since 2000-2001, when prices fell 63%.

Investors have bailed out of bullish bets and as a group are betting for prices to keep falling, according to Commodity Futures Trading Commission data.

The following is a graph which illustrates the magnitude of the 3 year continuous decline in coffee prices:



Were it not for poor speculation, this type of decline should have actually been a major boon to Farmer Brothers. The WSJ noted that:

Meanwhile, retail prices for bagged coffee and lattes have stayed relatively steady, a boon for roasters and food companies that are able to capitalize on lower coffee costs.

So just how bad has the impact been from wrong way derivative bets by Farmer Brothers management ? Here are a few examples.

In May, the company released 9 month results in which it proudly noted that its gross margin had improved by 4%. However this was during a time in which coffee prices (as disclosed by the company) had declined by more than 30%. Even if Farmer Brothers had passed on the majority of the real market savings to its customers, it still should have shown a dramatic surge in margin, but the company enjoyed almost no benefit at all.

It also announced that losses on coffee derivatives for the 9 months had already exceeded $10 million, an even larger loss than the $8 million in the 9 months from the preceding year.

The size of this loss was attributed to a “four fold increase” in the number of coffee related derivative contracts purchased covering 34.8 million pounds of coffee vs. 9.4 million pounds of coffee in the prior year. Yet revenues had increased by less than 2%.

When coffee purchases increase by 300% to cover a 2% increase in sales, this is called speculation, not hedging.

Beyond the past losses, it is disclosed that it expects to continue losing more on the derivatives:

Based on recorded values at September 30, 2013, $8.2 million of net losses are expected to be reclassified into earnings within the next twelve months.

As of April 1st, 2013, the company began implementing procedures to apply ASC 815 for its “derivatives and hedging”. The stated goal of this is to

minimize the volatility created in the Company’s quarterly results from utilizing these derivative contracts and to improve comparability between reporting periods

Investors who are interested can click here to read the accounting guide from PWC on this subject. Those who choose to click the link will see that the summary guidance is over 500 pages long.

There are several points from this. First off, the goal of these accounting treatments as implemented by the company should arguably not be to “minimize the volatility created in the quarterly results”. Instead, it should be to present the fair value of the derivatives activity in which the company is engaging. That way there will be no sudden and dramatic “mark to market” surprises in coming quarters.

Perhaps of greater importance is the fact that this 100 year old company is now engaging in more sophisticated and risky activities which were likely never envisioned by its founder. When the founder had been running this company in simpler times, Farmer Brothers was consistently profitable and paid a healthy dividend. The diversion into derivatives speculation has coincided with the company canceling its dividend as it continues to lose money each year.

The current installment of Farmer family descendents into roles of responsibility does not help matters. Based on any disclosure of their educational and professional backgrounds, most investors would find it highly unlikely that either of the retired Farmer homemakers and school teachers would be able to navigate and explain the nuances of derivatives speculation and the appropriateness of the resulting accounting issues for transparency to investors. The same could likely be said for the Farmer who serves as “Vice President of Coffee”, but whose background is not disclosed.

As we saw in October, when there were suddenly large losses and restatements, these individuals were, not surprisingly, caught 100% off guard.

These observations should in no way be construed as personal aspersions against the current members of the Farmer family. The point is simply that as a public company, these family members should not be entitled to oversee the business when they have not demonstrated any relevant qualifications. The results of their oversight have been ongoing losses, financial restatements and risky derivatives speculation by management which have then been rewarded with excessive compensation.

Perhaps of greatest importance is the fact that many investors seem entirely unaware of the derivative losses. For 2013, Farmer Brothers reported an accounting net loss of $8.4 million. But this entirely ignoresadditional “Deferred losses on derivatives designated as cash flow hedges” which totaled an additional $7.9 million.

The additional losses incurred from derivatives was nearly as large as the total loss from selling coffee in the operating business. But this is only disclosed “below the line” in Other Comprehensive Income (Loss) and can be found on page 38 of the 10K.

How concerning is the pension benefit restatement ?

Companies which employ many people and which have been in business for an extended period of time typically suffer disproportionately from the burden of post retirement benefits. The most widely recognized example of this would be General Motors.

Farmer Brothers currently employs around 1,800 people. But having been in business for over 100 years (more than 60 years as a public company), the company has a fairly large built up obligation from post retirement benefits.

As of its fiscal year end, Farmer Brothers had a Projected Benefit Obligation(“PBO”) of $132.2 million while the Fair Value (“FV”) of its plan was just $92.4 million.

As a result, its plan is under funded by about $40 million.

The company disclosed that

We expect to make approximately $1.3 million in contributions to our single employer defined benefit pension plans in fiscal 2014 and accrue expense of approximately $0.7 million per year beginning in fiscal 2014. These pension payments are expected to continue at this level for several years, and the current economic environment increases the risk that we may be required to make even larger contributions in the future.

The accounting for post retirement benefits is complicated and is subject to many management assumptions. As a result, many investors find themselves completely befuddled by it and find it easier to simply ignore these liabilities and expenses, focusing instead on the operating business which is easy to understand.

But for companies with obligations which are very large relative to their balance sheet, these expenses and liabilities can entirely outweigh the results of the operating business. This is what we ultimately saw with GM (although obviously GM is a very extreme example).

Point #1 – the pension obligations are very large relative to equity in the company

For Farmer Brothers, the size of the PBO liability (using current assumptions) is $132 million. Total equity for Farmer Brothers is just $84 million. The point is that this $132 million obligation is very large relative to its equity.

Point #2 – the obligations and underfunded status are simply management’sestimates

The second point to be made is that this already large obligation is simply anestimate of what the company will actually owe and is subject to assumptions which are being put forth by Farmer Brothers management. The biggest point of sensitivity for the PBO is the assumed discount rate. The lower the rate, the higher the obligation becomes. We are currently still in an environment of extremely low interest rates. Yet the company assumes rather high discount rates of 4-5%. This results in a projected benefit obligation which is lower than should really be the case.

In looking at the largest one of the pension plans (the “Farmer Brothers Plan”), each 0.5% decrease in the discount rate increases the PBO by $8 million. (See page 24 of the 2013 10K) So if the company were to instead assume a 3% discount rate, the PBO would rise to around $150 million. A 2% discount rate would cause it to rise to around $166 million. This then comes to double the shareholders equity in the entire company.

For reference, 10 year treasuries are currently sitting at around 3%, which are still at 3 year highs. One year ago (including the reference period for the current 10K which assumes 4-5%) treasuries were at just 1.76%.

The level of underfunding can be analyzed the same way. With a Fair Value of $92 million, the pension plan appears to be underfunded by $40 million using current management assumptions. But with a 2% discount rate, the level of underfunding alone would be around $75 million (almost equal to the total shareholders equity for the entire company).

Investors should also note that there are multiple plans to consider: the “Farmer Brothers Plan”, the “Brewmatic Plan” and the “Hourly Employees Plan”. For simplicity, the numbers above refer only to the Farmer Brothers Plan because it is notably the largest.

So investors need to ask themselves how large is Farmer Brothers actual pension benefit obligation and how large is the actual shortfall? Investors also need to handicap how and when Farmer Brothers will end up funding the shortfall. Given that the company has failed to generate a real profit since 2007, it seems more likely that the company may be forced to issue a substantial amount of equity in order to remedy this shortfall.

Point #3 – Fluctuations in pension obligations outweigh the total income / loss for Farmer Brothers

As with the deferred losses on derivatives, the changes in the funded status of the pension plan are treated as “Other Comprehensive Income (Loss)” and can be found on page 38 of the 10K.

In 2013, the fluctuation in the underfunded status of the pension plan amounted to an improvement of $10.9 million. This is greater than the magnitude of the entire reported net loss ($8.5 million) for all of the company’s operating business of selling coffee. But because this is reported “below the line”, most investors are entirely unaware of the magnitude of these swings.

And by looking at the (now restated) numbers for 2012, we can see that the funded status in that year fell by $26.5 million, which was basically equal to the $26.5 million loss the company incurred for its entire operating business of selling coffee.

So again, the point here is that changes in the status of the pension plan (which are heavily dependent upon management assumptions) have been of equal or greater impact on Farmer Brothers than its entire business of selling coffee.

As a result, the fact that Farmer Brothers has been unable to properly estimate and account for its pension liabilities and was forced to restate 3 years of financials is of very extreme significance. In fact, it is of far more consequence than the issue of how much coffee is Farmer Brothers selling.

The fact that the company has now restated these financials with E&Y should be of very little comfort. E&Y missed all of these problems in the first place, blessing the 3 years of results. Shortly after E&Y reviewed and once again blessed the restated numbers, they were they replaced as the auditor for Farmer Brothers.

Given the huge impact on the financial health of Farmer Brothers, this will obviously be the first area which is subject to scrutiny by new auditor Deloitte.

Looking at past behavior of management and the board

As shown above, the restatement of 3 years of financials was announced in September. But there are very clear signs that management was well aware of these problems at a much earlier date.

As far back as May (4 months before the restatement was announced), the company had suddenly amended and restated the audit committee charterwithout any explanation for why these changes were suddenly deemed necessary.

Even a brief read of this document filed in May will strongly suggest that the board already knew that there were problems with the ongoing financial statements and was looking to shift blame to the auditor and towards management and away from its own members.

For example, the restated audit committee charter states that

Additionally, the Committee recognizes that the Company‘s management, as well as the Company‘s independent auditors, have more time, knowledge and more detailed information concerning the Company than do Committee members.

Consequently, in carrying out its oversight responsibilities, the Committee isnot providing any expert or special assurance as to the Company‘s financial statements or any professional certification as to the work or independence ofthe Company‘s independent auditors. In addition, auditing literature, particularly Statement of Auditing Standards No. 100, defines the term “review” to include a particular set of required procedures to be undertaken by independent auditors. The Committee members are not independent auditors, and the term “review”as applied to the Committee in this Charter is not intended to have that meaning and should not be interpreted to suggest that the Committee members can or should follow the procedures required of auditors performing reviews of financial statements. Furthermore, the Committee’s authority and oversight responsibility do not assure that the audits of the Company‘s financial statements have been carried out in accordance with GAAS.

Again, the timing of such a strange document is noteworthy.

This document was released just 4 weeks before the end of the fiscal year ended June 30th, 2013. This was the 10K which included the 3 years of restatements. It seems quite clear that the board had already been informed of problems with the previous financials.

Clearly all elements of the business (including the financial statements) fall under the responsibility of CEO Michael Keown. But the detailed day-to-day involvement would have largely been the responsibility of former CFO Jeffrey Wahba.

It should be noted that Mr. Wahba resigned from the company earlier in 2013, and continued on as a consulting CFO until May 22nd. One week after the end of the CFO’s employment (following 3 months of consulting by him) the company chose to issue the audit committee restatement.

As we can see, that restated audit committee charter clearly shifts blame towards management and the auditor. By the time the restated document was released, the CFO had already discontinued his employment. And now, by the end of the year, the auditor has already been replaced. The point is that in May, these actions indicate that the board was already aware of the problems. They had shifted the blame away from themselves and now they have completed the process by eliminating the CFO and the auditor.

But here is the kicker. Although management and the board certainly knew about these problems, investors were entirely in the dark. In May, the share price had been trading as low as $13. By the time the auditor was replaced, the share price had traded to over $24.

Despite impending problems, CFO Wahba reaped a large windfall upon his departure. Much of this would clearly require board approval from the compensation committee which is chaired by Ms. Farmer Grossman.

Technically, Mr. Wahba resigned his employment with the company effective February 28th, 2013. But he continued to provide his “consulting services” to the company as CFO into May at a rate of $285 per hour. For this few month period of service (which ended right as 3 years of his financials) were about to be restated, he received $795,000 in compensation. For reference, in 2012, Mr. Wahba worked for the entire year on a full time basis and received a full year bonus and his total compensation was $1.1 million. The point is that Mr. Wahba was extremely well paid for doing a short duration of work – which then culminated in the restatement of 3 years of financials which were signed under his watch. It is yet another example of Farmer Brothers providing excessive cash compensation to members of management despite dismal performance.

But the real payoff for Mr. Wahba came when he sold all of his stock. Even though he was still providing his consulting services to the company through May, Mr. Wahba sold all of his stock in company during the first week in March, immediately after he technically resigned. He sold 100% of his shares at prices of around $13, bringing in around $2 million.

On December 11th, Hortensia Gomez, the Vice President and Financial Controller sold 390 shares of Farmer Brothers stock for around $9,000. This amount is clearly not large, but based on the disclosure in the proxy, Gomez did not appear to have any other meaningful ownership of stock.

On the very next day, December 12th, the company filed an 8K to announce a “Separation Agreement” with Gomez. As with Mr. Wahba above, the terms of the separation appear to be very favorable for Ms. Gomez. Ms. Gomez will stay on for a transition period of about a month and will be paid severance of $150,000.

This announcement came just 2 weeks before the announcement that the auditor was being replaced.

On page 11 of the proxy, we can see that among all members of management, none of them have any meaningful ownership of stock in the company. Management members are in fact required by the company to own some amount of stock. But we can see that no member of management or the board (other than members of the Farmer family) hold even 1% of the shares in the company.



Members of the Farmer family continue to own around 37% of the outstanding shares, with Ms. Farmer Grossman holding 892,444 shares valued at around $20 million.

Management has demonstrated a strong preference for being compensated primarily in cash. For 2013, CEO Michael Keown received $1.6 million in compensation, mostly in cash.

Total compensation to management in 2013 came to around $4 million. To put this in perspective, management’s compensation alone amounted to around 50% of the company’s total loss of $8 million in 2013.

Farmer Brothers stock has been in the hands of the Farmer family members for generations now. They have shown no intention of selling substantial amounts of stock regardless of whether the price is high or low. The fluctuations on the share price therefore have very little impact on them at all.

But for members of management who do not already own stock, they have very little exposure to the long term share price movements. As a result of this, it creates the risk that they can be more focused on short term results which can be driven by pension accounting, derivatives speculation and other short term accounting techniques. When these provide any boost to the numbers, they are then compensated heavily and in cash.

Looking at the LIFO accounting

Any company which deals in perishable goods will invariably take steps to ensure that the goods they acquire are distributed as quickly as possible and that they are distributed in a “First in, First Out” (ie. “FIFO”) manner. This is common sense and is done simply to prevent spoilage. Farmer Brothers can certainly be expected to sell first the coffee it acquires earliest.

But from an accounting standpoint, the company has elected to report its inventory and COGS using the LIFO (“Last In, First Out”) method. This is particularly advantageous in a period of falling prices because they company always appears to be selling the cheapest coffee first, while holding as inventory the more expensive (“more valuable”) coffee.

The price of coffee beans of various varieties has been in a steady 3 year decline, with prices continuously falling by more than 50%.

If Farmer were to pay $2.00 per pound to buy coffee in January, but only $1.00 per pound to buy coffee in February, Farmer would then report that it is selling all of the $1.00 coffee before ever having to sell any of the $2.00 coffee. This means that gross margins are substantially higher because Farmer always appears to be selling the “cheapest” coffee first. It also overstates inventory because the “more expensive” coffee is held on the books.

LIFO accounting will always deliver superior accounting results in an environment where a company s seeing falling input prices. At the end of the year, Farmer then conducts what is known as a “LIFO Liquidation” where it attempts to “true up” this discrepancy. But because Farmer keeps buying more and more coffee, these older purchases at much higher prices are simply never reflected. This is true even though the physical coffee that was purchased at much higher prices was actually physically sold long ago. This means that the real margin is in fact much lower due to the higher prices paid for coffee at the time.

In any event, the ultimate impact of this LIFO accounting is not fully known until the end of each year, such that quarterly results can be misleading.

The company discloses this in the recent 10Q as follows:

Inventories are valued at the lower of cost or market. The Company accounts for coffee, tea and culinary products on the last in, first out (“LIFO”) basis and coffee brewing equipment manufactured on the first in, first out (“FIFO”) basis.The Company regularly evaluates these inventories to determine whether market conditions are correctly reflected in the recorded carrying value. At the end of each quarter, the Company records the expected beneficial effect of the liquidation of LIFO inventory quantities, if any, and records the actual impact at fiscal year-end. An actual valuation of inventory under the LIFO method is madeonly at the end of each fiscal year based on the inventory levels and costs at that time.

If inventory quantities decline at the end of the fiscal year compared to the beginning of the fiscal year, the reduction results in the liquidation of LIFO inventory quantities carried at the cost prevailing in prior years. This LIFO inventory liquidation may result in a decrease or increase in cost of goods sold depending on whether the cost prevailing in prior years was lower or higher, respectively, than the current year cost. Accordingly, interim LIFO calculations must necessarily be based on management’s estimates of expected fiscal year-end inventory levels and costs. Because these estimates are subject to many forces beyond management’s control, interim results are subject to the final fiscal year-end LIFO inventory valuation. The Company anticipates its inventory levels at June 30, 2014 will be same as of June 30, 2013 and, therefore, did not record an adjustment to cost of goods sold for the three months ended September 30, 2013. No adjustment to cost of goods sold was recorded for the three months ended September 30, 2012.

By contrast, Starbucks uses a more accurate moving average cost rather than LIFO. Likewise, Green Mountain Coffee uses a method which is in line with FIFO, as opposed to the unusual use of LIFO at Farmer Brothers.

In any event, during the recent multi year price decline in coffee, Farmer Brothers use of LIFO accounting has been able to benefit interim gross margins and is inconsistent with other players in the coffee space.

Self insuring to save money on insurance premiums

The LIFO accounting above is inconsistent with the physical flow of goods through Farmer Brothers. It is also a short sighted way to provide an apparent boost to gross margins.

Likewise, the company has chosen to self insure itself rather than pay full insurance premiums. This is the case even though the company has disclosed that it does not meet minimum credit criteria to participate in such a program in its home state ofCalifornia.

According to the 10K

In May 2011, we did not meet the minimum credit rating criteria for participation in the alternative security program for California self-insurers. As a result we were required to post a $5.9 million letter of credit as a security deposit to the State of California Department of Industrial Relations Self-Insurance Plans. As of June 30, 2013, this letter of credit continues to serve as a security deposit and has been reduced to $5.4 million.

The full impact of the decision to self insure against these substantial risks is large enough that it is included as its own separate risk factor.


We are self-insured for many risks up to significant deductible amounts. The premiums associated with our insurance continue to increase. General liability, fire, workers’ compensation, directors and officers liability, life, employee medical, dental and vision and automobile risks present a large potential liability. While we accrue for this liability based on historical experience, future claims may exceed claims we have incurred in the past. Should a different number of claims occur compared to what was estimated or the cost of the claims increase beyond what was anticipated, reserves recorded may not be sufficient and the accruals may need to be adjusted accordingly in future periods.

The company justifies its decision to self insure based on the fact that in the past it has not faced many substantial clams. This is no different than a homeowner rejecting insurance because his house has never burned down in the past. The entire purpose of insurance is to provide small payments which are known in advance and fixed in order to avoid unknown catastrophic losses later.

As with the pension errors and the substantial derivative speculation, the short sighted decision to boost the short term bottom line by virtue of self insuring does not seem to be a responsible one for any company which seeks to serve the best interests of long term and risk averse shareholders.


Shares of coffee related stocks have been strong performers over the past year, in part due to the falling prices for coffee beans which has helped to boost margins. In the past 12 months, shares of Starbucks are up 37%, while Green Mountain Coffee is up 74%. Small cap Farmer Brothers is roughly a double.

Enthusiasm for coffee related stocks has helped to boost Farmer Brothers despite the fact that it continues to lose money and despite the fact that much larger problems are quickly emerging.

Relative to other players in the coffee space, Farmer Brothers is a small company which has a limited following and limited research coverage. As a result, many of its substantial problems have gone largely unnoticed and the stock has simply been buoyed by strong sentiment for coffee stocks in general.

It is now the case that the true economic results for Farmer Brothers are more heavily impacted by the results of derivative speculation and pension obligations than by the actual business of selling coffee. But investors have missed these items because they are reported “below the line” of reported net income.

We have now seen meaningful resignations within the finance department and have seen the auditor replaced. This all happened along with a substantial restatement of the audit committee charter, which distanced itself from 3 years of inaccurate financials.

Members of the Farmer family have been able to exert substantial influence on the company despite little to no background in managing a public company. This becomes more concerning in light of the fact that the company is now facing much larger problems with growing derivatives losses and a pension obligation which is underfunded by at least $40 million.

The mistakes which occurred over the past 3 years were blessed by both management (the finance team) and by auditor E&Y. All of these parties are now gone and the going financials books will now be evaluated by new auditor Deloitte.

Given the history of problems and the increasingly complex situation at Farmer Brothers, there is a substantial risk that a stringent audit by a new auditor will reveal even larger problems for Farmer Brothers.

Farmer Brothers spent much of 2012 in the $7-8 range. This was before the ramp of in money losing derivative speculation, before the 3 year financial restatement and before the replacement of the auditor.

As these problems come to a head (and to the extent that they become a focus of new auditor Deloitte), Farmer Brothers should certainly be expected to return to levels of $7-8 or below. This would still value the company at well over $100 million.

Disclosure: I am short FARM, . I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.


The big picture at Unilife (UNIS)

unis needle image

Investment considerations

As bulls and bears debate their longer term expectations for revenues at Unilife, many have missed the fact that there are near term catalysts which can be expected to have a very certain impact on the share price well before these longer term forecasts have a chance to play out.

Investors should also pay close attention to the stock promotion efforts which have accompanied the recent press releases and they should be aware of some nearly identical promotions in the past. As shown below, these types of stock promotions can often create more bounce in the share price than the actual news released by the company itself.

Separately, investors who wish to assess the longer term revenue prospects should make themselves aware of the current competitive environment. Many investors appear to have missed the existence of numerous competitors with similar product offerings who already have substantial cooperation from big pharma players.

As a final consideration, many investors have engaged in substantial debate over two negative articles which were published in Forbes in September. These articles contributed to significant volatility in the share price when they discussed a whistle blower lawsuit brought against Unilife by a former employee. Many investors appear to have never read the actual lawsuit and instead have simply relied upon the interpretation as represented by Forbes. Anyone with a longer term interest in Unilife should certainly read the suit themselves and come to their own interpretation. I have included as an Appendix a link to the full lawsuit text filing along with several text excerpts.

Section 1: Long term theses vs. near term catalysts

Last week was a volatile one for shareholders in Unilife (UNIS).

On Monday, the shares had traded as low as $4.03, closing at $4.15. But after the market closed, Unilife announced ”an agreement with Novartis to supply clinical products from one of its platforms of injectable drug delivery systems for use with one of Novartis’ targeted early-stage pipeline drugs”.

The mere mention of “an agreement with Novarits” had a predictable effect on the share price, and Unilife quickly traded as high as $5.25 in extended hours trading – an immediate gain of more than 25%.

These gains followed similar gains the previous week, following theannouncement of a long term supply agreement with Hikma Pharmaceuticals on November 20th. Just prior to this announcement, the stock had closed at $2.80.

After trading to as high as $5.25 in extended hours, the shares ended the week at $4.31, but had traded as low as $4.16 again on Friday. In other words, by the end of the week, Unilife had already given up almost all of its sharp gains following the Novartis release. The stock has already received price target upgrades from its three investment banks last week, but this appears to have provided very little support for the share price.

An outpouring of analysis on Wednesday added to the volatility in the share price, but appears to have not given much direction to the share price. In that one day, there were three large short articles and two large long articles published. These authors took turns repeating one another, contradicting one another and ignoring one another. All of this also happened to occur on the same exact day that CEO Alan Shortall was presenting at a conference in New York. Not surprisingly, the share price was very volatile that day, at times being down by 10% or up by 5%. It was equally unsurprising that the share price finally ended the volatile day almost entirely unchanged (up by just 2 cents).

The bull thesis is based on the opinion that this recent series of supply agreements will ultimately produce perhaps hundreds of millions in revenue from big pharma partners. However, even the bulls acknowledge that meaningful revenues are not expected to materialize until after several ramp up periods of as long as four years.

The bear thesis was fully detailed by Kerrisdale Capital which notes that recent announcements from Unilife are nearly identical to numerous announcements stretching back 10 years, each of which suggested that the onset of massive revenues was imminent. Such announcements had consistently caused the share price to soar dramatically, just as they have again done in the past two weeks. As they have been recently, analysts were then quick to upgrade the stock. Yet revenues for Unilife have continued to dwindle while Unilife has steadily issued nearly 40 million new shares in just the past few years.

For those looking to trade the stock, the inherent problem with both of these bull and bear theses is that both are predicated on how potential contracts and revenues will play out over a period of several years. Given the tremendous volatility in the stock recently, long term views may not be of ideal use.

Both sides are free to speculate on the longer term future of Unilife. However in the near term, one thing is quite certain: By the end of December, Unilife will likely be out of cash and the company is almost certain to issue a substantial amount of equity before the Christmas holiday. This is the near term catalyst.

Author Dr. Hugh Akston illustrated this catalyst quite clearly in a recent article. As of September 30th (i.e. two months ago, its last reported quarter), Unilife was down to just $7 million in cash. The company steadily burns around $3 million every month. The company did receive $5 million as an upfront payment from Sanofi in October, but Unilife has already disclosed that it plans on paying down a loan to Varilease for roughly that amount. As of right now, Unilife is therefore down to around $1 million in available cash vs. its consistent cash burn of around $3 million per month.

The incentive to conduct a very large equity offering is clearly substantial. Last week (following the sharp spike), Unilife had quickly risen by nearly 90% and was trading at its highest levels since 2011. But this is simply on a “nominal” share price level. In reality, the large number of shares which have been issued every year means that last week Unilife was closing in on its highest evervaluation (market cap) since coming public in the US. Some investors may not realize this given that the share price has fallen from above $10.00 to around $4.00 at present. Yet it remains the case that the market cap for Unilife had just hit within around 10% of its highest ever valuation since trading in the US.

The recent upgrades by Unilife’s investment banks were all based upon enthusiasm for the Novartis announcement. Yet these banks are not privy to any additional information beyond the press release, which we can all read equally well. The banks simply relied upon this simple press release to provide generous upgrades to their share price targets. Such jockeying for position ahead of a near term equity financing suggests that these banks are looking for an equity offering that will be bigger rather than smaller and which will provide millions of dollars in investment banking fees to whoever is selected by Unilife. Currying favor with the company by upgrading the stock should therefore have been fully expected. These upgrades have failed to support the stock, so it appears that the market has already come to this realization on its own.

Section 2: Evaluating the stock promotion efforts

When looking at the “big picture” at Unilife, investors need to understand that there is an active effort at stock promotion which has been going on for quite some time. The details from this particular effort are virtually identical to other stock promotions, some of which I have highlighted in past articles.

Here is how it typically works. (And readers should keep in mind that I am not specifically referring to Unilife in this description. I am referring to a cookie cutter process that can be seen very frequently across numerous micro cap reverse merger stock promotions)

In each case, the promotion involves a small, money losing reverse merger which supposedly has the potential for massive near term transformation along with billions in revenue potential. At some point, the company issues one or more press releases which happen to mention global mega giants within its industry. Specific terms which would allow for proper revenue forecasting are typically not disclosed for competitive reasons or due to “confidentiality”. The share price often moves to some extent based on these press releases. But much sharper gains appear when certain third party authors interpret these press releases for us and then issue massive multi bagger share price forecasts. Share prices can then often show additional gains of more than 50% in a very short period. But the gains are typically very short lived. Over time most of these promotion efforts end up giving up all of their gains, and in many cases they end of falling even further, for reasons that will be shown below.

On Friday, author Tech Guru weighed in once again to help us “parse” the debate on Unilife. He notes that he expects $50 million in revenue in 2014. By way of comparison, over the past 5 years, Unilife has generated a cumulative total of only around $25 million in revenues. But most of this came in 2010. More recently, revenues have dwindled to around $0.6 million per quarter. During this time span of several years, Unilife has repeatedly issued similar bullish forecasts which made statements such as:

we have been swamped with demand from a lot of other pharma companies who also have unmet needs.”

“We expect to be supplying this to many pharma companies in the near future,”Allan said.”

Past press releases dating back as far as 4 years include the following. (Note these are all PRIOR TO 2013, and as such should have already had an impact on revenues).

2010 - Unilife and sanofi-aventis Agree to Exclusivity List for Unifill(TM) Ready-to-Fill Syringe

2010 - Unilife and Stason Pharmaceuticals Sign Asian Distribution Agreement for the Unitract(TM) 1mL Safety Syringe

2011 - Unilife Signs Clinical Development and Supply Agreement with Global Pharmaceutical Company

2011 - Unilife Wins Supply Contract with Nation’s Largest Healthcare Alliance

2011 - Unilife Starts Unifill Syringe Sales to Another Pharmaceutical Customer

2011 - Unilife Commences Initial Supply of the Unifill® Syringe to Sanofi

2011 - Unilife on Schedule to Fill Initial Orders for Unifill Syringe

2012 - Unilife’s Bolus Injector Platform Targeted by Global Pharmaceutical Company for Use in Multi-Drug Program

2012 - Unilife Signs Long-Term Supply Contract for the Unifill Prefilled Syringe

In many cases, these press releases were just as exciting as the recent ones in 2013. They also consistently provided (very brief) boosts to the share price of Unilife as expected.

But the results have varied dramatically vs. expectations.

The points from these graphs demonstrate the following: the share price has been steadily declining for the past several years, even as Unilife has consistently issued millions of new shares. Likewise, revenues have dwindled by more than 70% while losses have grown substantially. All of this has occurred despite the consistent release of “news” from Unilife which has been largely similar to that which was released in the past few weeks.

It is therefore unclear how Tech Guru could be so optimistic regarding a tremedous surge in revenue next year.

A few months ago, I highlighted a different campaign by Tech Guru with Neonode Inc. (NEON), which appears to be nearly identical to the promotion of Unilife in virtually all respects. The similarities and parallels here should be patently obvious to anyone who has followed Unilife.

Tech Guru began writing on Neonode earlier in 2013. Between March and September, he wrote bullish articles on the company on average every 2-3 weeks. Neonode is engaged in licensing touch sensor technology, mostly to electronics OEMs.

Just like Unilife, money-losing microcap Neonode had put out several very promising press releases this year which could be linked to global giants within its industry. Over a period of months these included such heavy weights as Samsung and LG, along with automotive contracts with Volvo. Clearly this was going to be huge and transformational.

Just like Unilife, Neonode had been putting out nearly identical press releasesfor years, but consistently failed to generate meaningful revenues – despite the global giant partners. Just like Unilife, Neonode has never earned a profit in its numerous years in business. And just like Unilife, the press releases from Neonode were always kept vague and omitted the most relevant details, typically due to competitive or confidentiality reasons.

Given that multiple years of nearly identical press releases from Neonode failed to produce large scale revenues or any profits at all, it is unclear why Tech Guru would project that more identical press releases in 2013 would somehow lead to near term windfall profits and a skyrocketing share price. But by trumpeting names like LG and Samsung and predicting returns of more than 400%, his articles did cause the share price to briefly rise by around 60% to as high as $8.84 up from around $5.00 in March.

Just like with Unilife, the investment bankers were quick to upgrade Neonode based on nothing more than the very vague press releases. Investment bank Craig Hallum initiated coverage on Neonode when the stock price was just $3-4, and put a target of $7.50 on the stock, implying that they expected Neonode to double. The timing of this coverage was downright bizarre given that Neonode had just lost its largest customer, Amazon (AMZN), which had been responsible for 40% of its revenues at the time. But the upgrade worked and Neonode rose. By August, Neonode had still failed to replace its lost revenues and reported a notably large earnings miss which sent the stock plunging by more than 20%. What did Craig Hallum do ? They upgraded the stock again – now with a $10.00 target. This upgrade, along with more bullish articles by Tech Guru (predicting a $27 share price) sent the stock to just under $9.00. This sequence of events is all detailed clearly in my September article.

By now, this sequence of events should all feel very familiar to those who follow Unilife. So far they have been largely identical.

What happened next with Neonode was quite predictable. Neonode and its management sold $19 million in equity. Craig Hallum ran the deal (as expected) and made millions in fees. Meaningful revenues from the mega announcements may still be years away (if ever) and the stock price quickly fell by around 30% back to around $5.00 – right where it began. Prior to the offering, Tech Guru had been writing bullish articles on Neonode every 2-3 weeks for a 5 month period. This was a dedicated and persistent effort. But following the offering, the articles suddenly ceased for several months.

Many investors may wonder if such promotions can actually have a meaningful impact on the share price. The answer is a categorical “yes, they can”, especially if executed by a professional. This point can be made clear with a separate example.

Lately the Novartis news has taken center stage to the point where many investors have stopped focusing on the recent Hikma news from November 20th. The Hikma announcement caused Unilife to soar by more than 30% to $4.03. But after the initial surge, investors began a meaningful sell-off as they fully evaluated the news. It was only a double promotion from a paid subscription service called “The Focused Stock Trader” that sent Unilife soaring.

The graph below illustrates the sequence of events.

- Nov19 / 20 – Unilife announces Novartis news – stock rises to $4.03

- Nov21 – UNIS stock immediately trades down as low as $3.63 (down 9.9%) closes at $3.73

- Nov22 – 25 – UNIS struggles to hold above $4.00

- Nov26 – TFST promo article to paid subscribers only - UNIS immediately jumps from $3.85 to as high as $4.38 (13% jump and a new 52 week high).

- Nov27th – TFST article released on SA at 2:35 pm – stock jumps again from below $4.20 to as high as $4.50 (breaking yet another 52 week high)

- Nov28th – Thanksgiving – market closed

- Nov29th – Friday – stock closes at $4.40

- Dec 2nd – Stock closes at $4.15 (down 6%) hitting a low of $4.03 again (right where it began)

- Dec 2nd (after market close) – Novartis news released

The conclusion from this is that the stock had been quickly falling below $4.00 until it was pumped up by TFST and his distribution to his subscriber and then the follow through on Seeking Alpha. The stock was quickly losing momentum again, and the only thing the resurrected it was a new press release regarding Novartis.

TFST is a paid stock promotion letter. According to its results page, TFST is among the best investors in the entire stock market throughout the history of time eternal. Better than Buffet, Ichan or Soros by a long stretch. It notes that:

As our results show, The Focused Stock Trader recommendations were correct 52 out of 55 trades for an average return of 29.69% per trade with 2 trades generating returns in excess of 200%. The average holding period for our recommended trades, not including open trades, is 24 days. THE FOCUS STOCK TRADER HAS BEEN CORRECT 95% OF THE TIME GENERATING 30% EVERY 24 DAYS.

Apparently by following TFST, one can quickly become immensely wealthy. Fortunately, TFST makes its expertise available to the public, for anyone willing to pay $400 per quarter ($133 per month) or $1,200 per year ($100 per month). Based on this, it is very easy for TFST to pull in a 6 figure income from subscription revenue irrespective of the performance of any trades it recommends.

closer look at TFST reveals that many of these stock picks end up being for very speculative reverse mergers which demonstrate great volatility. The research underlying them is often questionable, yet TFST has apparently generated significant returns on the upside, quickly selling before these stocks fall back to Earth.

For example, back in August, TFST highlighted Organovo Holdings (ONVO). Histrack record notes that he had sold the stock for prices as high as $11.20. But when the stock was trading at over $12.00, I highlighted the fact that much of its gains were due to misinformation and inaccurate comparisons to 3D printing stocks such as 3D Systems (DDD) and Stratysys (SSYS). The article from TFST contains the exact type of misinformation that I had referred to. He noted that

Needless to say, Organovo can do for 3-D printing what Microsoft (MSFT) did for PCs and Ford (F) did for the automobile; make a long-sought after dream a reality.

Shortly after TFST was selling at $11.20, the stock quickly ended up falling below $8.00. The stock has recently jumped due to the CEO’s presentation at retailinvestorconference.com. But even on that conference, the CEO went out of his way to make clear that Organovo is NOT a 3D printing stock.

TFST clearly benefited from the rise in the Organovo even though its research was largely unfounded. So, what’s the harm ?

The harm is that when stock promoters put out unfounded research on tiny, speculative reverse mergers, investors end up buying into these stocks without understanding that there are very substantial risks. TFST’s next pick was Fab Universal (FU), which he ended up making a whopping 99% on, selling it at $10.75. Congratulations to TFST, however that stock has since been halted after a fraud expose by GeoInvesting. Prior to the halt, this stock had last traded at $3.07. Trading has not yet resumed. Anyone who has been stuck holding a Chinese microcap which has been halted due to fraud allegations would likely not hold much optimism for the future of Fab. TFST was smart enough to get out at $10.75, but its subscribers may not have been so lucky. On its website TFST notes that:

In our reporting, we will suggest the purchase point; however, it is up to you to decide when to close out the position.

Likewise, on Unilife, we will have no idea how quickly TFST will end up running for the exits. In fact, it may well be the case that TFST will have the benefit of selling to individuals who are still buying based on research provided by TFST. That advantage, along with over $100,000 per year in subscriber income, makes for a great business model for TFST.

A longer look at the TFST track record shows a predisposition towards speculative and volatile reverse merger stocks which often end up in the cross hairs of short sellers. Revolution Lighting (RVLT) which TFST was selling as high as $5.00 was later exposed by a short selling and fraud focused site the StreetSweeper. The stock subsequently fell by as much as 50% from where TFST was selling, and it now sits at around $2.80. But it appears to have been another great trade for TFST who got out early. Likewise, it is very difficult to understand how anyone could have ever recommended beleaguered OCZ Technology (OCZ) which has been on terminal status for over a year.

TFST had noted that :

Short sellers are still holding on, but perhaps not for long. OCZ’s short position is at an unsustainable 79.3%.

Within a month, the shares had already plunged by around 80%. Since that time the shares have fallen by more than 95% and now trade for around 10 cents. It looks like there was a reason why the short interest was so monumental.

Yet OCZ has continued to be a promo pump target even now. Ashraf Eassa recently warned that there is still a pump campaign trying to spread rumor of a buyout on this now dead stock.

In separate disclosure on November 29th, TFST noted that his holding periodwas as short as just 14 days. The point is that small reverse mergers can often pop due to the sensation which surrounds vague press releases. This is especially true when the press releases include the names of major, global industry players. As players such as TFST have demonstrated, the best way to profit from such hype is to buy the rumor and (very quickly) sell the news.

The promoters behind Unilife have demonstrated a consistent tendency to back speculative, money losing reverse merger stocks. As with TFST, other backers have found themselves on the opposite side from short sellers.

Tech Guru had previously penned an article to rebut the short thesis on Coronado Biosciences (CNDO). Coronado had the implausible idea of making medical treatments out worm eggs which grow on pig feces. Tech Guru sought to debunk the short thesis which had been highlighted again by such skeptics as the StreetSweeper.

In its “public oath” the StreetSweeper states that:

We aim to partner with the public in exposing corporate fraud and bringing its engineers to justice. To that end, we pledge to investigate credible allegations of misconduct and – if the evidence supports those accusations – report the truth about our findings. At the same time, we agree to disclose any conflicts that could potentially color our judgment. By embracing these core principles, we hope to protect ordinary Americans and deliver them news that they can trust.

Readers can take that “public oath” with whatever grain of salt that they like. The point from it is that sites such as the StreetSweeper do not focus on stocks which are merely overvalued by 10-20% or which might have a bad earnigs quarter. They are focused on catalysts which are far more dramatic and which imply far larger share price moves.

As with Unilife, the shorts made their case by saying citing a horrible track record by management, including huge share sales despite no revenues. In backing this company, Tech Guru was defending the indefensible. As should have been expected, the use of worm eggs from pig feces failed in clinical trials and the share price plunged from over $8.00 to as low as $1.25. Yet the elevated share price before the failure allowed management to raise over $200 million from stock sales over the past few years. The shorts were particularly focused on the fact that a small group of insiders had been repeatedly involved in similar speculative ventures which soared on the hype but which imploded following large share sales. Since the implosion of Coronado, Tech Guru has ceased providing further updates on the company.

The point from these examples is that generating excitement around tiny reverse mergers which generate little to no revenue is far easier than generating excitement around larger companies which are profitable and stable. This is precisely why promoters choose such companies. Yet by ignoring or denying the warning signs highlighted by the skeptics, these promoters can often encourage other investors to invest in stocks which have very significant (and unknown) downside potential.

Other Unilife bulls appear to be engaged in a different strategy when writing about Unilife.

In the past year, Fusion Research has gone from zero articles on Seeking Alpha to almost 400. A new article appears from them on almost every trading day, with the result that Fusion is now #1 on long ideas, #1 on services stocks and #1 on industrial goods. These rankings are based purely on number of hits.

Fusion describes itself saying:

Fusion Research is managed by a team that has been actively involved in the financial research industry for over 5 years. Our business is rooted in principles of trust, integrity and fundamentals-driven markets.

But it also notes that

We create strategic partnerships with companies and firms to gain unprecedented domestic and international following of our coverage.

In fact, a closer look at Fusion’s own website reveals that Fusion is actually an IT outsourcing firm which focuses on simple web development and HTML. There is a link where once can “learn more” about its investment research activities. But that link is broken and leads to nowhere.

In its almost 400 articles, Fusion has consistently written about mega cap stocks which have a huge built in following of thousands of readers. But it has also made it a point to write about smaller stocks which have recently shown dramatic price moves and which will also automatically generate a large number of hits.

The key point is as follows: During a two week period, shares of Unilife soared by as much as 88% on the back of two press releases which are encouraging but still far too vague for planning or forecasting purposes. Prior to this, the shares closed at $2.80 and the shares have already begun a substantial retreat.

The attention of promotional authors can often have an even larger impact than the news from the company itself. While this can often create great short term trading opportunities for those who are nimble, holding these stocks after they peak can end up producing substantial losses on the way down. Investors should be aware that those who promote such stocks often have zero intention of holding the shares and often intend to play it as a quick “buy on the rumor trade”. Other authors are simply attracted to the most volatile stocks which tend to generate the largest number of page views and typically do not even buy the stocks they are writing about.

Section 3: Competitive considerations for Unilife

Many of the recent articles have been overwhelmingly focused on highlighting the dramatic upside associated with Unilife, while downplaying the substantial risks of buying on this spike. They have also ignored the competition.

There is a reason why promotional authors tend to ignore the risks and competition: it works.

We can very easily see what happens when an author pays even moderate attention to risk elements after a stock has already spiked. Once the stock has spiked, any attention to risk can send it sharply lower.

On December 2nd, Dr. Thomas Carr wrote a very bullish article on Unilife entitled “Unilife: Set To Double In 2014?“. In his opening pitch, he notes that he is long the stock and that:

As it turns out, demand for Unilife’s unique medical dispensing technology is so strong and growing so fast that shares of the company may well be one of 2014′s best investments in the healthcare sector.

What was the result of this strong enthusiasm from one who identifies himself as a “doctor” ? The stock actually fell 7% that day. There are two reasons for this.

Despite his own personal bullishness and disclosing a long position in the stock, Dr. Carr was forthright enough to at least mention the substantial downside that comes along with Unilife. He noted that:

New and current investors should keep in mind the risks outlined above. The company may well be covering up past fraudulent activity. The Biodel deal may well fall through. Management may continue its unfortunate streak of over-selling its EPS potential.

But of much greater importance was the fact that Dr. Carr was among the first to pay more than passive lip service to the existence of substantial competition within this market.

Even Unilife itself discloses that there is meaningful competition in this space. But the mostly retail investor base in Unilife often seems to feel that Unilife is inventing a new product and will quickly command a monopoly in the space.

In its most recent 10K filing, Unilife discloses its view on the competition which already consists of some of the largest and best financed giants in the healthcare industry, saying:

We are aware of five companies which specialize in the production and supply of glass ready-to-fill syringes. These companies are BD, Gerresheimer, MGlas AG, Schott and Nuova Ompi. We estimate the market concentration rate for these five companies to be approximately 95%. We believe BD’s market share to be in excess of 50%, as it has supply relationships with most pharmaceutical companies and contract manufacturing organizations.

The point that investors need to realize is that this is not a soon-to-be-created new market which will be dominated by Unilife. It is already an established and highly competitive market.

In September, the big news for Unilife was the Sanofi contract which may eventually lead to meaningful sales of Lovenox in prefilled syringes. But in its September conference call, Unilife noted that

the IMS data for Lovenox for 2012 shows the sale of over 450 million prefilled syringes with Lovenox in it.

The point is that there are already hundreds of millions of units of being provided by competitors on the market two years before Unilife even plans on entering the picture in 2014. Many investors have been entirely unaware of this competitive reality and have assumed that Unilife is about to create a multi billion dollar monopoly.

Dr. Carr briefly listed a number of Unilife’s competitors within the space who have existing or pending product offerings which will largely compete within the same space.

In addition to Beckton Dickinson (BD), Gerresheimer, MGlas AG, Schott and Nuova Ompi (which were mentioned by Unilife), Dr. Carr also mentions such giants as Amgen (AMGN), Pfizer (PFE) and West Pharmaceuticals (WST). Medical giant Baxter International (BAX) is also active in prefilled syrniges. Baxter is valued at $37 billion based on annual sales of over $14 billion.

The point is that breaking in to this space will be difficult, even despite several encouraging potential supply contracts. The competition in this space is well established and extremely well financed and will have the ability to compete aggressively on volume, quality and price.


The market has now had the opportunity to digest in full the recent news from Unilife along with the ample analysis from third party authors. CEO Alan Shortall has had the opportunity to speak to investors in New York and the sell side analysts have already had their chance to upgrade the stock.

With all of these events now being mostly digested, the stock appears to be once again giving up its recent gains rather than continuing to surge higher.

The market may well be already pricing in an equity offering due to the realization that Unilife will likely be out of cash before Christmas.

Much of the sharp rises in the stock can be tied to recent promotional articles by authors who tend to focus on short term trades in speculative reverse merger stocks. In the past, some of these efforts have sensationalized press releases from other micro cap reverse mergers and have predicted a surge in near term revenues and multi bagger share price returns. This is an easy task when the press release includes the names of global giant heavy weights.

But when similar such press releases have been consistently issued for years without meaningful resulting revenues, investors should likely ask themselves how the latest series of press releases will create a result that is in any way different.

There is already existing competition in the specialty syringe space, with hundreds of millions of units being delivered even just for individual drugs such as Lovenox. Those who have been under the impression that Unilife has created a novel product and will soon be commanding a monopoly would do well to expand their research into the substantial competition in the specialty syringe space.

Appendix I – details of Unilife lawsuit

For those who wish to read the details of the Unilife lawsuit in their entirety, updating filings from August can be found at the following link at my website atmoxreports.com. Readers can also sign up for email alerts. There is no charge for this and email addresses are not shared with anyone. Ever.

Readers should also be aware that Unilife has already responded to the article on Forbes. A link to that response can be found here. However, readers should also note that there are a number of items in the actual whistle blower lawsuit which do not yet appear to have been responded to by management.

The lawsuit was brought by Talbot Smith, formerly an executive at Unilife who was hired in 2011. The suit notes that Smith was a Stanford graduate with a BS in Industrial Engineering and an MS in Operations Research. His starting salary was $230,000 plus various incentives including bonuses and stock options.

The gist of this lawsuit can be seen on the first page of the filing. The cited “causes of action” are a) violations of Sarbanes Oxley and b) violations of the Dodd-Frank Act.

Sarbanes Oxley (or “SOX”) was passed in 2002 in direct response to various accounting scandals including Enron, Tyco and Worldcom. SOX requires that top management certify the accuracy of SEC filings and dramatically increased the penalties for fraudulent activity.

Dodd Frank was passed into Federal Law in 2010 in response to the financial crisis which began in 2008 and also was designed to incorporate enhanced protections for investors.

As noted, the lawsuit was originally filed and received by the US Department of Labor/OSHA. The lawsuit notes that the Secretary of Labor did not make a final determination within the 180 day deadline, but that “sufficient prima facie evidence was found to begin an investigation” (page 2). As a result, the case was moved to Federal Court.

This filing is very long because it also incorporates original copies of the press releases and the 10K filing which are said to contain the inaccurate statements.

Some of the claims by Smith state that products being supplied by Unilife were not “validated” (as had been claimed by Unilife) because the FDA required activities had not been completed at the time that these statements were made to investors. Unilife subsequently brought in FDA auditors who stated that by the time of the audit, the validation could be considered complete.

These FDA claims will therefore be very difficult for either side to verify. The argument Talbot would make is that compliance would have been achieved well after he reported his observations to the FDA, but prior to the audit. The argument from Unilife is simply that this is not true.

Other claims should be less ambiguous. For example, on page 7, we can see Smith’s claim that the previous 10K filing made inaccurate statements to investors regarding shipments of “commercial” product by Unilife. Talbot backs this statement by noting that “no revenue had been collected from commercial sales of the Unifill product”. Ultimately, an audit by the SEC will be able to trace documentation of this claim and make a determination. This should be black and white.

Likewise, Talbot claims Unilife made false statements about its production lines. Talbot claims that at the time of the statements, two of the production lines were actually still in Denver, Colorado, and certainly not installed. Again, this should be a very black and white matter to resolve in an investigation.

In general, I am far less focused on the FDA issues because I believe that they will be far more difficult for either side to resolve. But on Page 11, the lawsuit describes additional product quality failures which had supposedly been reported by Smith via email. The lawsuit then notes that

The following day, Mojdeh told Smith to come into his office. Mojdeh instructed Smith that he should not put any concerns into emails because they could be used against the company in future legal action

Once again, an investigation will certainly dig up any emails prior to this conversation. Either the emails referred to by Smith exist or they do not, so there should be a conclusive result to an investigation by the SEC.

Other claims may be easy to document, even though actual “intent” may be hard to prove. On page 11, the lawsuit notes that:

Unilife also took actions to mislead investors about its customer demand and manufacturing capacity. To this end, Mojdeh directed Smith to have his team purchase 1,000,000 units of Unifill components per month in spite of the fact that there was no customer demand or manufacturing capacity to justify this level of purchasing. Mojdeh told Smith that the objective of the purchases was to make suppliers believe that Unilife was manufacturing at this volume, with the hope that the information would leak to the financial markets.

The point here is that proving that Unilife made unnecessary purchases at huge volume should be relatively straight forward. And this could easily be explained by the ballooning losses and dwindling revenues seen over the past 3 years. Yet actually proving the intent of Mr. Mojdeh will likely be a more difficult endeavor in an investigation or a courtroom.

On page 12, the lawsuit states that:

Another action that Unilife took to mislead investors was to run fake production when investors or customers were visiting the facility. On more than one occasion, scrap was run through the machines to make it appear that Unilife was making product when it was not. Product was placed on skids by the warehouse doors to give the false appearance that product was being packaged and send to customers when it was not.

Presumably the only way to get much resolution will be when the SEC subpoenas the warehouse workers who either did or did not perform these activities. The truth should be easy to get at because warehouse workers typically do not have a large financial inventive to bend the truth when faced with the potential for perjury charges. In addition, there are likely a large number of warehouse workers. Keeping a secret gets harder as the number of individuals increases.

On Page 13, the lawsuit notes that

Shortall made comments that were posted on the Yahoo! Finance message board on July 10th, 2012, indicating that Unitract was profitable with a 20% gross margin, when Unilife was in fact losing $1.00 per unit.

Again, this will be an easy one to either prove or disprove.

Conclusions regarding Unilife lawsuit

The details spelled out in the lawsuit vary between crystal clear and verifiable to murky and difficult-to-prove. Some investors may be inclined to wonder why we have not already seen some resolution to these matters given that they relate to issues dating back to 2011. Other investors may be inclined to feel that if we haven’t seen consequences yet, then there may simply be nothing to worry about.

In general, SEC investigations take considerable time and there are no “hints” along the way which would given guidance as to the eventual conclusion. For example, in October 2013 the SEC was just providing final resolution to the fraud case at YuHe International, which has been ongoing since 2011. China frauds were a big focus in 2011, and in October 2013 the SEC finally got around to issuing final judgment against China Media Express (“CCME”), also following fraud that was uncovered in 2011. The point is that these things can often take a few years before visible results are uncovered. No one should expect that there would have already been an immediate result just because these findings were made public over a year ago.

Disclosure: I am short UNISONVO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Organovo set to fall by 50%


Investment overview

Shares of Organovo Holdings (ONVO) have recently skyrocketed due to widespread media coverage and an equally widespread misunderstanding of the company’s near term revenue potential. The stock has risen from $2.00 to over $13.00 in the past 12 months and is now valued at over $1 billion. To date Organovo has generated no real commercial revenues, but has brought in small amounts of money from grants and collaborations. The company hopes to launch its first commercial product, a 3D liver assay, in December of 2014, 13 months from now. A launch of any possible next products has not been announced or discussed, but would likely take several more years for any visibility. So for now, this one product is all that there is to hope for for the next few years.

In July, Organovo conducted an equity offering at $4.50 per share. As a result, the company now has a cash balance of approx. 58 cents per share. Aside from the recently raised cash balance, the sum total of all of Organovo’s other assets is just $1 million.

On October 22nd, Organovo Holdings announced that it had presented data demonstrating retention of key liver functions in bio printed tissues for up to 40 days. In response to this, the share price rose modestly from around $6.50 to as high as $7.50 before retreating back below $7.00 once again. The news was out and the stock remained flat for around two weeks. This is clearly not what caused the stock to soar recently.

Starting on November 6th, about two weeks after the announcement, the stock began to take off. Most of this was due to a rapid fire series of bullish articles on the Motley Fool and Seeking Alpha which often came out on nearly every other trading day since the announcement. Many authors and investors have suggested that Organovo may be on the verge of a massive revenue opportunity of tens or even hundreds of millions of dollars in the near term.

During this brief time, the share price has nearly doubled, hitting a new lifetime high of $13.65. The company has nearly 90 million shares fully diluted such that it has now exceeded $1 billion in market cap. It should be noted that there has been no other news whatsoever from the company, only from bullish authors. Readers should also make note of the tremendous surge in volume which has occurred on no substantial news. The point here is that this spike was not driven in any way by the only significant announcement made by Organovo back in October.

Authors who suggest that Organovo is set to begin pulling in tens or hundreds of millions of dollars from sales of liver toxicology assays starting in December 2014 clearly do not understand this product or the market for it.

By now it is well known that drug companies risk losing billions of dollars when one of their drugs enters and then fails clinical trials. Liver toxicity is one of the most common reasons for a drug to fail. As a result, many of these authors have simply created a leap of logic that if the drug companies stand to lose billions, then Organovo must stand to make a fortune by introducing another diagnostic test for them. This isn’t how it works at all.

It is clearly the case that much of the overwhelmingly retail shareholder base simply does not understand the market for 3D liver toxicology assays. What they clearly don’t realize is that there are already competing 3D liver assays on the market right now, and sold in the US, which sell for as little as $1,750 per 96 well tray. Yes, these are 3D bio printed liver toxicology assays, which serve the same function as what Organovo hopes to offer. But Organovo won’t even begin for at least another 13 months from now. Retail investors are not aware of competing 3D bio printing companies because many of these companies are not public companies and / or are not US companies. Multiple examples of competing companies in the 3D bio printing space are shown below. Yet because they are not public they have not enjoyed almost daily bullish articles from places such as the Motley Fool.

It is clearly shown below that Organovo’s total revenue potential from 3D liver assays for Organovo amounts to just $3-5 million cumulatively from 2014 through all of 2016. This is because the total market size for 3D liver assays is limited to a few thousand units at most. By 2020, other product offerings (such as kidney assays) may eventually emerge, but so far there is still nothing definitive from the company at all. It should be kept in mind that Organovo has possessed its current technology since 2009, and developing this first product has taken 5 years. So investors should understand that the wait time until we see second product may also be a few more years.

Some of the confusion likely stems from the Organovo presentation which cites a $500 million market opportunity for cell assay products by $2018. The data came from “Scientia Advisors”. Investors need to understand two things. First, this market opportunity applies to an extremely wide variety of assays to be used across the market for a wide variety of uses. It will also be served by many competitors, not just by Organovo. Right now Organovo has in development just a single assay product to fit into this entire market, such that the size of the overall market has very little to do with Organovo’s financials over the next 5 years. Second, investors should be aware that the Scientia data was part of a “sponsored” study in which Organovo hired and paid the firm to produce these estimates

It should also be kept in mind that any revenue in the near term assumes that Organovo is successful in developing the product and that it is launched on time in December of 2014. Investors still bear the risk that the product either doesn’t work as well as planned or is delayed beyond December 2014. For now, we can give Organovo the benefit of the doubt and assume the best for this project. But investors must absolutely realize that the very best case, assuming success, is for a just few million in revenues (NOT a few hundred million). This will be clearly demonstrated below.

Just two weeks ago, prior to a surge in high publicity articles, the stock was sitting flat below $7.00. As the share price has risen due to over a dozen recent articles, management has been selling hundreds of thousands of shares in October and November and has filed a massive S8 registration statement by which they can now issue to themselves over 11 million new shares. This represents nearly 13% of the company in new shares, and would be valued at over $130 million, just for the personal benefit of a small group of insiders.


As should likely be expected, these insider sales and the large S8 equity registration statement escaped the attention of many investors because they have been consistently filed by Organovo management with the SEC on Fridays, and notably after the market was closed. As anyone would expect from this, most investors were quite obviously not even looking at their screen on a Friday at 5 pm. The most recent set of management stock sales came again last week. The SEC filings were released again on Friday. And again it was well after market hours when no one was looking. Links to these filings have been included.

As investors come to realize that Organovo currently has only a few million dollars in cumulative revenue potential over the next 3-5 years, it becomes very difficult to justify the lofty $1 billion valuation. These realistic revenue numbers are a dramatic variance from investors’ mistaken expectations of hundreds of millions of dollars. The biggest near term catalyst for a sharp decline is the ongoing insider sales the huge equity registration by management and the sudden realization that revenue potential is minimal.

Investors should therefore expect the share price to quickly return to below $7.00, where it was prior to over a dozen promotional articles on Organovo released in the past few weeks. As recently as November 5th, Organovo had traded as low as $6.61.

Important Note: The market data with respect to pricing and volumes of 3D liver assays should be seen as highly verifiable. This is how investors should estimate future revenue prospects. Links are included so that they can be verified by anyone. For investors who wish to conduct their own checks, I strongly encourage them to ask Organovo management directly about expected prices and volumes. Management can be reached at IR@organovo.com. Alternatively, investors can ask other 3rd party sources such as Zacks analyst Jason Napodano who has covered the stock or companies such as Insphero (shown below) which already sell 3D bio printed liver assays. These sources will yield estimates that should all be very much in line with the ones I present below.

Background information

Organovo is a stock which lends itself to significant misunderstandings by the market. It also lends itself to over promotion and manipulation. Despite all of the mainstream enthusiasm for 3D printing and bio printing, Organovo has just7% institutional holdings - 93% of the stock is held in retail hands. Stocks such as 3D Systems (DDD) are held in the majority by institutions.

Organovo has just one analyst who has covered it, Jason Napodano from Zacks. However, Mr. Napodano has recently dropped coverage of Organovo due to the valuation. On the Twitter page for TheStreet.com’s Adam Feurstein, a series of tweets and retweets between Feuerstein and Napodano now suggests that “At this price, I think $ONVO could be as much as 500% over-valued.”

When a stock is only owned by retail investors and there is limited research coverage, it is very easy for the stock price to be heavily influenced by articles in the media. This is especially true when the articles come in rapid succession almost every day. Of course, investors need to be aware that many of these very bullish articles come from those who happen to own the stock and would like to see it go up.

In arriving at my revenue projections, I conducted simple market analysis and identified competing 3D liver assays which are already being sold on the market. The price for these 3D liver assays is readily obtainable. It is also easy to estimate the number of units that might be sold in a year. According to clinicaltrials.gov, there are around 500 new drugs which enter phase 1 testing each year. Organovo might hope to gain a significant share of these. They might also hope to gain a share of roughly 1,000-2,000 other compounds that could be tested each year. Each 3D liver assay tray contains 96 wells which can be used to conduct independent tests. As a result, for any given drug, a single tray should be more than ample. Based on this, if Organovo was extremely successful and immediately captured significant market share, it might end up selling as many as 1,000 total units of these 3D liver assays in a year. As a result, we come up with a number of roughly $2 million per year in revenue to Organovo. But this is beginning in 2015 after the product is launched in December of 2014. For the year 2014, investors should remember that product revenue should be close to zero.

That is a very simple method of market analysis that helps us approximate total revenues for Organovo. It is not going to be precise down to the dollar, but it shows clearly shows the following:

There is precisely zero chance of Organovo reaping hundreds (or even tens) of millions of dollars in revenues over the next 3-5 years. Organovo management certainly can have no such expectations. Only the retail investors do as a result of a recent string of bullish articles. Even if an investor wants to arbitrarily double all of the assumptions above, it does not even come to $10 million cumulative revenues for the next 3 years total. Beyond 3 years, we have been given no indication when additional products will be launched.

In arriving at my unit calculations, I first used clinicaltrials.org. I then cross checked my numbers with those which had been prepared by Zacks, who had consulted directly with Organovo management when making their revenue estimates. As a final check, I spoke directly with Swiss company Insphero which already sells these 3D bio printed liver assays for drug toxicology. The results are all quite consistent at a maximum of a few thousand units per year for the total market size. Insphero is the company that sells these 3D bio printed liver toxicology assays for $1,750. More details are included below.

The market for 3D liver assays is simply not a large one, the prices are not very high, and there are already other competitive products actively selling in the market. Those who have projected hundreds of millions in sales have simply failed to look at the market for this product. Instead they simply (and falsely) assume that any product being sold to big pharma must automatically generate hundreds of millions of dollars.

It should come as no coincidence that my estimates above are very closely in line with the estimates of Zack’s research in their detailed initiation report on the company. On Page 16 of the report Zack’s shows clearly that the company is expected to generate revenues of $0.5 million in 2014 and then $2.0 million in 2015, going to as high as $4 million for all of 2016. Zack’s used a different method than I did in arriving at these estimates: they interacted directly with management in putting revenue estimates together.


I contacted Zack’s analyst Jason Napodano a few days ago to see if these revenue estimates were still valid or if anything had changed. He noted that his revenue estimates are still valid for upcoming years. Nothing has changed. Mr. Napodano has written on Organovo on multiple occasions and has been consistently positive on the company and on their technology and prospects. But because he has a much clearer picture of the realistic revenue potential over the next 3-5 years, he last maintained a $5.00 share price target for the share price. His last coverage was updated just 12 weeks ago.


But now we can see from the Zacks’s website that the company is no longer providing updates on Organovo. When I wrote to Mr. Napodano about this, he stated “I dropped coverage given the exorbitantly high valuation. Can no longer recommend people own it.”

A price between $5.00 and $7.00 is certainly where Organovo should be expected to trade in the near term. This is where it was just 2-3 weeks ago. This is well below the current levels and certainly below the lofty levels expected by those who have inaccurately suggested hundreds of millions in revenue.

We can contrast the market research approach to numerous other articles which have appeared in the press in recent weeks. On Friday, one Seeking Alpha author applied simple random guesswork in trying to calculate revenue potential stating:

We don’t how long it will take ONVO to reach $100 mill. to $200 mill. revenue, that might better support current prices, as there is not enough guidance from the company to make those projections. But a reasonable guess of going from $0 to $100 or $200 would be at least three years, which would put is in the FY 2017-18 timeframe as being the earliest when we would expect annual revenues to reach that level.

In fact, there are actually plenty of data points to help quantify just how much revenue Organovo can expect from its only product (3D liver assays) over the next 3-5 years.

This author demonstrated no research into the market and simply stated that by 2018 Organovo might be raking in as much as $200 million. This is a staggering amount of revenue and is in no way supported by anything that Organovo currently has in the works or has even envisioned in the near future.

(Perhaps by coincidence, when this article was released trading 3 days ago, CEO Keith Murphy filed to note that he had just sold another 100,000 shares. His filing to notify investors came after the close of the market on a Friday, so many investors might be expected to have missed this.)

Similar revenue projections in multiple other articles are the sole reason why the share price has doubled in the space of two weeks to its current billion dollar valuation. They have truly lit a fire under retail investors which then sparked momentum traders to pile in. But these types of projections for the next 3-5 years are entirely without foundation. They are wrong. When the momentum traders take the reverse direction on the stock, a significant correction should be expected. Momentum traders by definition do not even care what a company does. They only care about the near term direction of the stock. Momentum traders tend to pile in in force and amplify movements to the upside as well as to the downside. Yet they are “direction agnostic” and are just as happy to profit from a stock on the way down.

Over a ten year time frame, Organovo can be expected to attempt to develop other revenue streams such as assays based on other organs like the kidney. But these are years away and we do not have any visibility on when they might be launched. Organovo has possessed its current technology since 2009 and the first commercial product, the liver assay, will not be launched until 5 years after that time. In the more distant future, the real excitement for the company is the potential to develop fully functioning replacement organs for transplants. But this is even further away and has no impact on the current share price.

At present, the reality for all investors is that Organovo is only capable of producing liver tissues that are just 1 millimeter thick and which can be sold in trays for less than $2,000. Even this will not become a reality for another 13 months, and then only if all goes as planned. The notion that Organovo will reap hundreds of millions in revenues at any time in the foreseeable future is pure fiction.

There is already significant competition in the 3D bio printing space

Organovo is the only publicly traded company that is solely focused on 3D bio printing. This has led many investors to believe that it is the only company engaged in this business at all. This is completely mistaken.

Below I will list a quick 7 notably obvious direct and indirect competitors within the 3D bio printing space. Like Organovo, these companies are all involved in the printing of cell matter such as organ tissues using 3D bio printing technology. But readers should note that beyond these 7, there are many, many more for those who care to search around. As with Organovo, many of these companies have their roots within some of the worlds most prestigious universities and research institutes. (Organovo’s origins came from theUniversityofMissouri). These various competitors are active in theUS, Europe and inChina. Some of them are already are commercializing products well ahead of Organovo.

For example Swiss company Insphero sells 3D liver assays for drug toxicology and has partnered Cyprotex. A spin-off company of the Swiss Federal Institute of Technology (ETH) Zurich and the University Zurich, InSphero was founded in 2009 by Dr. Jan Lichtenberg, Dr. Jens M. Kelm and Dr. Wolfgang Moritz. On the Insphero website, these are very clearly marked as liver assays for toxicologyand they are very clearly marked as 3D bio printed products. These serve the identical purpose that Organovo hopes to serve 13 months from now. But for Insphero they are already on the market. The price comes in at just around $1,750 for each 96 well tray. Different tests can be run independently in each well, such that one tray is sufficient for 96 different outcomes. This means that one tray should be largely adequate to get test results for a single drug. Product inquiries forUS sales can be direct to sales@insphero.com or via theirUS sales number at +1 207 751-4908.


Insphero describes its current operations as shown below. This should look familiar to Organovo investors, except that Insphero has already been selling its product since 2012.


InSphero is a leading supplier of organotypic, biological in vitro 3D microtissues for highly predictive drug testing. The company, headquartered in Zurich, Switzerland, currently counts 7 of the top ten global pharmaceutical and cosmetics companies as customers. InSphero 3D Insight™ Microtissues enable more biologically relevant in vitro applications in efficacy and toxicology.

I did call Insphero directly and spoke to a sales representative who confirmed that the market for these 3D liver assays (which have been on the market for over a year) is only in the thousands of units total. The sales rep noted that in a large spike before the upcoming holiday season, the company actually shipped nearly 100 units in a week, which was extremely large. I also confirmed that the primary use of these tests (as with Organovo) is for drug toxicology testing by pharma companies.

Here is a screenshot from their website.


Yet another competitor is the Wake Forest Institute for Regenerative Medicine, run by Dr. Tony Atala. Their business should sound very familiar to those who follow Organovo. As noted in livescience.com.


Atala’s group has pioneered 3D printing methods that aim to build human organs with layer upon layer of cells. Their bioprinting methods lay down the cell layers along with artificial scaffolding to keep an organ’s structure intact as it takes shape – a technique that has allowed the group to make tiny, less complex versions of full-size human organs. “We’re printing miniature solid organs: miniature livers, hearts, lungs and vascular structures (blood vessels),” Atala told LiveScience.

WakeForestis far enough along in its development of that it has already been selected by the DoD to lead the following programs, as noted.

The Wake Forest Institute for Regenerative Medicine is leading the $24-million effort funded by the Space andNavalWarfareSystemsCenter, Pacific (SSC Pacific), on behalf of Defense Threat Reduction Agency (DTRA).

And then of course there is New Jerseybased Hurel Corp. which develops and commercializes similar 3D bio printed products. Hurel was a spin out from Schering Plough (now Merck) labs from 2007. The company is now backed by Sanofi. According to MedCityNews,

It [Hurel] has raised $9.2 million in a Series A round for its lead product – a technology that replicates the human liver, using living cells, and referred to asorgan-on-a-chip or human-on-a-chip.

Hopefully this also sounds very familiar to investors in Organovo, because this is in line with what Organovo hopes to launch in 13 months or so.

Beyond just livers, there are also other 3D bio printing companies focused on different tissues. Texasbased TeVido Bio Devices is focused on developing 3D bio breast tissues for breast cancer victims. This is similar to the larger and longer term ambitions that Organovo has for fully useable tissues. They havealready stated that they expect that it will take 7 years and at least $40 million in order to get to the beginning of clinical trials. Companies such as TeVido and Organovo can therefore expect a long and expensive slog before they are even able to contemplate the beginning of FDA trials on such products.

But competition for developing 3D tissues and assays is not just limited to Europe and the US. It has become an explosive business in China. Already theHangZhou University of Electronic Science and Technolgy is printing 3D bio printed body parts. Likewise a company called Unique Technology based inQingDao has already supplied its 3D bio printers to dozens of universities acrossChina.


There is also competition emerging offering to provide 3D bio printers more broadly to other organizations. Germanybased envisontec already commercially sells a 3D bio plotter which can be viewed here.

For those who wish to look further, there are dozens more institutions and organizations which are actively involved in 3D bio printing. For those who are interested in seeing many more, I included a short list of the 3D bio printing partners who work with Insphero as Appendix II.

The first issue here is that there are numerous other 3D bio printing entities aside from Organovo and that some of them are clearly further along than Organovo.

But the more important issue is that these dozens of other 3D bio printing entities do NOT get the benefit of daily hype articles from sources such as the Motley Fool. This is simply because they are not publicly traded and no one (ie. motivated shareholders) benefits in the short term from giving them excessive hype and sensationalism. It is very important for investors to realize that speculative companies with tradeable stocks get far more attention than their private counterparts simply because traders want to profit from stock moves.

Looking more closely at the 3D liver assay product

The low price of the 3D liver toxicology assay should not come as a surprise to anyone who knows pharma testing. 3D liver assays will not fully replace traditional testing methods anytime soon. The pharma companies will still conduct first line animal testing, and will then proceed on 2D liver tissue samples and then conduct the 3D test last.

The concept of a “3D bio printed liver toxicology assay” sounds very exotic (and presumably expensive) to many retail investors, but in fact it is just another fairly simple diagnostic test for pharma companies. Many investors might not realize that the thickness of these “3D” samples is in fact just a mere 1 millimeter. It hardly appears to be “3D” at all, but it does in fact meet that definition from a technical perspective.

At present the biggest technical challenge is in creating the vascular structures for delivering blood that is necessary to support thicker structures, so 0.5-1.0 millimeters is the current limit for thickness of these tissues. We could certainly print thicker samples with a bio printer. This is physically achievable. But they would quickly die for lack of blood flow. At less than 1 millimeter the blood circulates by simple diffusion such that vascular structures are not necessary.

According to Organovo CEO Keith Murphy,

Murphy cautions. “Our ability to make tissue thicker than about one millimeter is restricted by our ability to deliver nutrients and oxygen to the cells. Today, nobody can integrate the small vessels and capillaries needed for thicker tissue. Therefore, we’re not making whole organs,” he stresses, although doing so may become possible eventually.

This reality may come as a shock for those who envision Organovo as a company which prints large and thick human organs using a 3D bio printer. Many are not aware of the 1 millimeter limitation. The reality is that even getting to just one millimeter in thickness has been a massive challenge and accomplishment.

The real point is that for pharma companies this just another simple 1 millimeter liver diagnostic which will hopefully offer additional predictive value prior to determining whether or not to go into clinical trials. And we can see that the cost of these tests is around $2,000 or less for a 96 well tray which gives the ability to conduct 96 individual tests. Interested readers should feel free to verify these numbers with Organovo management, with companies such as Insphero or with analysts such as Jason Napodano or other 3rd party sources.

It all comes down to Intellectual Property (“IP”)

The reason that there are so many competitors in the US, Europe and China is that there are still tremendous amounts of IP which are available through hundreds of universities which have been focused on 3D bio printing for as long as a decade. There are many ways to achieve similar ends and 3D bio printing is still in its infancy. As a result, patenting one’s own process certainly does not prevent others from obtaining their desired outcomes through slightly different means.

The technology being used by ONVO was licensed from the University of Missouri in 2009 for just $25,000 along with 1-3% of future revenues, if any. In 2010, the company entered into further licensing agreements for additional technology for just $5,000 plus reimbursement of patent costs. In 2011, ONVO entered into similar licensing agreements withClemsenUniversity for a total of $32,500 plus an additional $32,500 in patent costs.

As of 2013, the value of all of ONVO’s non cash assets (ie. all of its intellectual property) was valued at less than $900,000. This should not be surprising when one realizes that the only product currently on the horizon is the drug toxicology liver assay which commands a low price of less than $2,000 and a small market size of perhaps 1,000 units per year.

In the meantime, ONVO only spends a mere $1 million per quarter in R&D expenditures.

Significant transformation in the world of technology and biotech is tremendously expensive. This holds true without exception. For example 3D systems still spends over $10 million per quarter on R&D even though its technology seems to be at a more mature state. And in developing an electric car that will actually sell, Tesla Motors (TSLA) spends over $50 million per quarter !

By contrast, Organovo spends around $1 million per quarter and its total IP (which it purchased) is valued at well under $1 million.

The one thing that Organovo has done quite successfully is to raise over $60 million from investors due to the strong share price. Yet much of the share price strength has resulted from hyper bullish articles from authors who engaged in pure speculation about bio printed full organs and other outcomes which are clearly decades in the future. Despite all of the hype and the soaring share price, the stock continues to be held 93% by retail investors and has attracted no mainstream Wall Street research coverage. In fact, the heaviest source of promotion for Organovo is via the presentations atRetailInvestorConferences.com. This should be seen as highly unusual even for companies with market caps even as small as $200-300 million, and certainly unusual for a company which has now surged to over $1 billion.

The point from this is that there is a very clear reason why Organovo has attracted no institutional or research interest. Organovo bought some very inexpensive IP 5 years ago. The company spends very little on R&D and its only near term product offering is for a simple diagnostic which is already on the market from other competitors. Meanwhile, Organovo has heavily targeted retail investors and has been able to use that hype to raise around $60 million over two years from stock sales.

What are the insiders doing ?

Looking at the insider behavior at Organovo is very interesting.

Over the past few weeks (and as the share price was soaring due to articles), CEO Keith Murphy has sold 200,000 shares of stock, bringing him in nearly $2 million. On each case his SEC filings were stealthily submitted after the market close and on a Friday, such that many investors may not have seen this at all.

Chief Strategy Officer David Eric has also sold nearly 100,000 shares.

CTO Sharon Presnell recently sold 75,000 shares, and sold and additional 75,000 shares in August.

Of greater concern is the fact that on November 8th, Organovo filed a massiveS8 registration statement which now covers 11 million shares to be issued to management. This represents nearly 13% of the company and would be valued at well over $100 million for this small group of individuals. S8 filings are often sources of concern for investors because they basically allow management to issue large amounts of stock to themselves or their “consultants” for any reason. The filings can be done on very short notice. S8 filings were a much abused vehicles by Chinese reverse merger companies during the wave of fraud that hit these companies in 2010-2011. They used these S8′s to issue large amounts of stock to themselves and their cohorts and then quickly sold the stock at highly inflated prices. S8′s were largely how many of the Chinese fraudsters made themselves rich. This does not mean that all S8′s are bad. It just means that it is an easy way for insiders to award themselves tremendous amounts of stock on very short notice. Investors should rightfully view large S8′s with skepticism.

And by the way, this recent S8 registration statement by Organovo was again stealthily filed by management on a Friday (Nov 8th), well after the close of the markets such that most investors did not even see it. The filing of this massive S8 fortuitously coincided with the recent ramp of the stock following a string of bullish articles.

The point from this is that management can feel free to sell as many of their current shares as they wish, because they know that they can simply issue themselves another 11 million more.

Going back further, we can see other interesting insider activity.

As of the initial public offering in 2012, company founder Gabor Forgacs owned 13.9% of the company. As an owner of more than 10% of the company, he would have been required to report any sales of his stock.

Also at that time, his son Andras Forgacs held 1.8% of the company and was a director. This is below the 10% threshold, but as a director he would still have to report any share sales.

By December 2012, Gabor Forgacs had reduced his stake to 12%. But by April of 2013, he had reduced it to 9.7%, beneath the 10% reporting threshold. This was just prior to the uplisting in 2013, when the stock soared for the first time to over $8.00, up from around $1.00 a year earlier. And by being below the 10% threshold, Mr. Forgacs would not have to report that he sold his stock. We can see from SEC filings that Mr. Forgacs has not provided any information about holding any Organovo stock since 2012. Mr. Forgacs resigned from the board in 2012 such that this stock sales also would not be reportable. We therefore cannot tell how many (if any) shares Mr. Forgacs still holds. But the pattern of his actions appears to have been conducive to being able to sell when he wanted to without having to report the sales which would alert investors.

Meanwhile, his son Andras resigned from the company in July 2013, also as the stock had just hit all time highs at the time. This would also allow him to sell his stock without reporting it. There are also no subsequent updates indicating that Mr. Andras continues to hold his original position so we really don’t know.

The last filings indicating ownership by the Forgacs were in March of 2012.

But perhaps a bigger question for investors is why did the founder and his son resign from this company at all ? If the future is so bright for Organovo, then presumably these two founding insiders would want to go along for the ride.

A word on Organovo’s collaborations

Like many development stage biotech and healthcare companies, Organovo was able to secure several collaborations with big pharma names. In 2010, they secured a deal with Pfizer and by 2012 they had delivered constructs to Pfizer for internal evaluation. No update has been provided since then as we now approach 2014. In 2011, Organovo entered into a research agreement with United Therapeutics. The agreement had later been expanded, but it appears that it still expires several months from now. In January of 2013, Organovo entered into a collaboration agreement with the Knight Cancer Institute atOregonHealth & ScienceUniversity (“OHSU”), to develop more clinically predictive in vitro three dimensional cancer models with the goal to advance discovery of novel cancer therapeutics. However this is purely academic and does not appear to provide any revenue to Organovo. Additional recent announcements have been made including Hoffman LaRoche and L’Oreal but no revenue from these has been disclosed either.

These name brand collaborations have added instant credibility and have occasionally boosted the share price. But the fact remains that in the past these big names have paid up to have a look at what Organovo has for them, and then they have moved on after looking.

This should be readily apparent by looking at the amount of collaboration revenue which has been steadily dwindling each quarter. As of the most recent quarter, Organovo brought in just $23,000 in collaboration revenue. By contrast, in 2012 the total for the year was over $1 million.

Learning from the past – have we seen this before ?

At the beginning of 2013, Casey Research published an article describing the then-recent moves in the stock, which were also spectacular. The description provided by Casey is now about a year old, but should seem oddly familiar to those who have witnessed the moves of the past few weeks. Investors should read this carefully, keeping in mind that it describes a the effects of a promotion that happened over a year ago !.

From Casey Research:

ONVO went public at $1.65 per share on February 14, 2012 and experienced some impressive momentum out of the gate, climbing to $3.01 (an 82% increase) by May 17. That’s when things really went crazy. Just one month later [IN JUNE 2012], ONVO traded as high as $10.90 (a 560% increase from the close on its first trading day just four months prior) after some of the larger newsletter companies like Motley Fool wrote numerous positive articlesabout the company and helped propel it to a $500-million market cap (despite no change in fundamentals) virtually overnight.

Think about that for a second. ONVO was trading for half a billion dollars despite generating less than $1 million in revenue during the prior twelve-month period. Yes, that’s a price-to-sales ratio of over 500. And it’s not like theforward one- or even two-year revenue projections were calling for growth that could come close to justifying that valuation. The numbers just didn’t make sense. When investors once again came to their senses and recognized this reality, the stock fell – hard. By mid-July 2012, ONVO was once again trading below $2.00 per share. Despite a brief pop above $3 per share in mid-October, the stock remained flat through mid-December.

The point from this excerpt is that we have seen the exact same phenomenon again. It is a series of hyper bullish articles (also coincidently coming primarily from the Motely Fool) all coming at the same time which sent this stock soaring within 2 weeks and without any new fundamental developments from the company. Casey makes a good point as well. Investors shouldn’t be looking at the current price to sales ratio, they should be looking at the 2-3 year forwardprice to sales ratio. As shown above, revenue for 2015 should not be much more than $2 million under any circumstances. But now we are at over a $1 billion market cap such that the forward price to sales ratio is still at least 500 times projected sales. And even if they grow these sales in 2016, we are still talking about 200-300 times sales.


There is an old saying that if you repeat a lie often enough, it becomes “the truth”. This does not mean “truth” in the literal sense, instead it just means that the lie becomes universally accepted.

Lately the headlines have been filled with bullish articles on Organovo which predict massive near term revenues as a result of providing billion dollar savings to big pharma companies. Many of these articles have been written by individuals who happen to own stock in Organovo and who have certainly derived great benefit from the recent doubling of the stock in two weeks.

The actual truth is that Organovo hopes to launch a fairly simple 3D liver assay in 13 months from now. It is hoped that this product will offer some incremental benefit above and beyond animal testing and 2D testing. Existing products are already on the market and sell for less than $2,000 for a 96 well tray. The total market size for all such liver assays for all competing suppliers numbers in the mere thousands of units.

As a result, Organovo’s revenue potential should be expected to add up to just a few million dollars over the next few years – certainly NOT hundreds of millions of dollars. And in fact, NOT even tens of millions.

But the sheer repetition of this misinformation of late has caused Organovo’s share price to double in about 2 weeks, now hitting a $1 billion market cap. The latest surge has been driven by high volume momentum traders who do not even care what the company does. These traders are also agnostic about share price direction. They are just as happy to profit from falling share prices as they are from rising share prices. They can exacerbate downward moves in the share price just as they have exacerbated the recent upward moves. As a result, as soon as investors realize the reality of Organovo’s actual revenue potential, the share price should be expected to see dramatic moves lower on very high volume.

In the meantime, management insiders continue to sell large amounts of stock at current prices pulling in millions of dollars personally. And now they have registered over 11 million more new shares to give themselves. Organovo as a company will certainly not be pulling in $100 million in revenue any time soon. The only ones to get this much money will be Organovo management when they personally award themselves the 11 million shares of stock under the recently filed S8.

Appendix I – practical considerations for shorting Organovo

Following the dramatic spike in the share price, many investors have lamented to me that shorting Organovo is often “impossible” due to lack of stock borrow..

A much better alternative is to sell the December call options. When selling options with a fairly low strike price of $5.00, the performance is basically identical to shorting the stock. Investors get 1:1 exposure on both the upside and the downside. The only drawback is that if the share price falls below $5.00, the investor no longer benefits from additional downside. But the major advantage here is that selling calls does not require the short investor to borrow stock, so there is no expensive borrow fee. In reality, selling naked options like this is often no more risky than shorting common stock. It does require an additional level of option approval from one’s broker, but this is well worth it because this technique applies to many stocks aside from Organovo.

Another alternative is to buy the “in the money” puts. Many investors shy away from puts because they are seen as being a very risky “all or none” bet. That certainly applies to “out of the money” puts. But if the stock price is below $12.50 and the investor buys $12.50 puts, he is already “in the money” and the option will largely perform 1:1 on the way down just like being short stock. As with selling calls, the short investor does not need to pay the expensive borrow. However there is typically a moderate premium that must be paid. So if the stock is at $11.50, the investor might pay $1.50 for the $12.50 put, effectively getting short at $11.00. Because the stock is at $11.50, the investor has paid a 50 cent premium. One advantage here vs. being short the stock is that if the share price does rise dramatically, the investors losses are capped at that $12.50 level. But should the stock fall back to $8.00, this $1.50 bet pays off $4.50 (a triple). And again, if the stock rises above $12.50, the investors losses are capped.

Appendix II – A few more 3D bio printing partners who you’ve likely never heard of

Cyprotex, UK

Cyprotex is an expert in-vitro CRO, that is using InSphero 3D liver microtissues for compound de-risking


Hamilton Robotics

A leading global supplier of liquid handling robots with proven 3D experience.Hamilton’s systems are in use at InSphero for large-scale production of microtissues.


INTEGRA Biosciences AG

Offers a range of automated hand-held and bench-top pipetting instruments ideally suited for production and assaying of 3D microtissues in InSphero’s GravityPLUS Platform.


Luxcel Biosciences Ltd., Ireland

Luxcel Biosciences develop and provide phosphorescence and fluorescence based sensors for use with InSphero 3D microtissues.


Perkin Elmer Corp.

Working closely with InSphero on integrating InSphero GravityTRAP assay plates for 3D microtissues into their Opera and Operetta High-Content Analysis systems for functional imaging.


Promega Corp., USA

A leading supplier of assay kits, who works closely with InSphero since 2010 to validate and to optimize assays for use with 3D microtissue spheroids.



Develops genetically modified 3D microtissue solutions using InSphero’s GravityPLUS system.


Solentim Ltd., UK

The fully automated bench-top system CellMetric for measuring visual, non-invasive cell content will soon support automated assessment of 3D microtissue size in the GravityTRAP plate.


Sophistolab AG, Switzerland

InSphero’s partner for histological analysis of 3D microtissues with a strong expertise in immuno-staining and microtissue handling.


Disclosure: I am short ONVO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.


TearLab to plunge on steep earnings miss

dry eye

Investment thesis

TearLab Corp (TEAR) has so far managed to drive moderate increases in revenue over the past year, but only by spending a disproportionate amount on marketing. The result has been ballooning losses in every quarter. The company has never earned a profit. Following dozens of recent calls to the offices of eye doctors, it has become apparent that the adoption of the TearLab product tends to be fleeting and driven primarily by the marketing spend. As a result, the temporary boost in revenues resulting from this marketing tends to be short lived and must be constantly replaced with new doctors who will give the product a trial. Investors should be concerned that TearLab now gives away its desktop reader for free in order to encourage doctors to make a trial of the product.

TearLab recently laid out a large seven figure pay package (roughly in line with a full quarter’s revenue) to hire Seph Jensen from Alcon Labs. His start date was scheduled to begin just prior to the upcoming earnings release. This expensive hire should also signal the company’s desire to telegraph a much needed turnaround to stem ballooning losses. The timing was likely urgent in order to have a visible solution in place prior to announcing disappointing earnings. TearLab is likely to report a much larger loss on revenues which are flat to down. The result is expected to be a share price decline of at least 25% to around $8.50 or below. The hiring of Mr. Jensen will be positioned as a means of addressing these problems going forward. On the earnings call he will certainly announce the company’s plans for reducing the ballooning losses.

Background information

Lately I have done quite well on several trades by aggregating information from non-market sources ahead of earnings releases and placing my bets accordingly. There is nothing illegal about this. Information which can be obtained by customers, suppliers and competitors is all fair game as long as it is not supplied by company insiders. As described below, Tesla (TSLA) follower Craig Froehle recently conducted similar analysis right ahead of the $25 plunge at that company.

In August, I wrote an article just before the release of earnings at Francesca Holdings (FRAN) which predicted that an earnings miss would lead to a 30% drop in the share price. A few days later, Francesca disappointed as predicted and the share price quickly fell from $25.00 to less than $18.00. Analysts had continued to maintain price targets as high as $38.00, so they were wrong by about 90%.

More recently, I predicted a similar 30% drop upon the release of earnings by Ignite Restaurant Group (IRG). Analysts had predicted that earnings might decline a bit, but continued to maintain price targets of around $17-18. Following the release of earnings this week, Ignite quickly traded down to below $11.99, also a nearly 30% decline from the time of my article a few days earlier.

To me, both of these trades were painfully obvious. Rather than rely upon the bullish views of sell side analysts, I turned off my computer and left my desk to conduct my own research in person. With Francesca, I visited numerous stores in various cities over the span of several months. I then called dozens more and scoured the internet for evidence of discounting. In its prior earnings call, Francesca had noted that its practice of deep discounting was coming to an end and margins would rebound accordingly. Analysts believed and repeated this view almost verbatim. But my months of research showed that the discounts were actually accelerating rather than declining. A steep earnings miss was all but guaranteed. When it was reported, the stock quickly plunged as it should.

Prior to writing about IRG, I visited and called numerous restaurants across multiple states and interviewed employees on each occasion. I also aggregated information on the availability of discounts. It was clear that the company’s turnaround strategy was failing and that traffic was falling despite heavy discounting. The combination of much lower traffic along with deep discounts meant that IRG was all but guaranteed to report a loss rather than the analyst-predicted profit for the quarter. As expected, the share price dropped to below $11.99, closing in on a new 52 week low.

This type of analysis is now becoming more widely used by a wider array of investors. Investors have come to realize that the reports and targets of sell side analysts are typically useless or downright dangerous. They are often little more than gratuitous quotes from management along with lofty share price targets which get re-raised every time the share prices rise.

Just prior to the release of Q3 earnings by Tesla, Seeking Alpha author Paulo Santos wrote an article highlighting Craig Froehle’s use of VIN number tracking to get an estimate of vehicle production and sales at Tesla Motors . Mr. Santos states that

The VIN data continues to be consistent with U.S. demand for the Model S having peaked, and indeed, it’s now consistent with that demand having already weakened substantially.

One day later, seemingly bullet proof Tesla began a plunge of more than $30. The point is that this type of grass roots analysis is becoming far more useful in predicting share prices and earnings than the reports of ever bullish sell side analysts.

An earnings miss at TearLab should now be obvious

Just one year ago, TearLab was trading at below $4. The stock has since risen as high as $15 – almost a quadruple. At its peak, TearLab hit just over half a billion in market cap.

The driver for the rise in the share price over the past year has been analyst enthusiasm over revenue growth. On a percentage basis, the revenue growth has in fact been quite large, in the range of triple digit percentages. But this is simply due to the fact that it is growing off of a very small base of just over $1 million. The rise from a $4 share price to a $15 share price has occurred even though revenues have risen from around $1 million to just around $3.5 million. Yet the quarterly loss has increased from $2 million to over $12 million.

Recently the stock has been trending down towards $10 in advance of the upcoming earnings release. The reason should become apparent.

TearLab most recently reported revenues of just $3.5 million, up by $1 million from the previous quarter. But its net loss ballooned from $8 million to $12 million in a single quarter. The problem is clear. In order to increase revenues by just $1 million, TearLab must incur a massively disproportionate increase in its net loss.

Over the past few quarters, this revenue trend has looked as follows:

(click to enlarge)

Analysts have been operating under the theory that at some point TearLab will end up generating enough revenue to break through the losses. But it should be kept in mind that the TearLab product has been on the market for over 5 years and significant sales have yet to materialize. The recent growth of $1-2 million in sales has been largely the result of a sharp increase in marketing spend. The result of the heavy spending has been the steep surge in losses.

This might be an acceptable strategy if it was one that led to a sustained increase in revenues in the long run. But with TearLab, it appears that the marketing spend is often successful only in getting doctors to agree to an initial test of the system for a limited period of time. When they fail to continue using it, it means that the marketing spend is largely wasted and the revenues evaporate. TearLab then continues with its marketing spend in an attempt to get more new doctors to conduct an initial rest of the system.

TearLab’s most recent earnings call was very brief. The company reported record revenues of over $3 million in a quarter, but the company lost over $12 million for the quarter. As a result, the company has already lost more in 1H 2013 than it did for full year 2012, its previous worst year ever.

The revenue vs. net loss for TearLab over the past 4 years is as follows. (The last column on the right is YTD 2013).

(click to enlarge)

Instead of discussing the earnings miss directly, the majority of the earnings call was spent hearing a panel of hand selected experts offer their praise for the TearLab system. Of the 4 individuals, 3 were eye doctors while 1 was the CEO of the OCLI eye practice.

At the risk of stating the obvious, it should come as no surprise that the panel of 4 which were hand selected by TearLab had very positive things to say about the product. Among the doctors, some of them had been long term TearLab supporters going back for multiple years. For example, Dr. Marguerite MacDonald is featured in TearLab’s investor presentation and has served as a TearLab promoter for several years (as seen here on YouTube in 2011). Her support for TearLab has been unwavering, but it sheds little light upon the adoption of the product by newer doctors who are not dry eye aficionados.

A much more instructive approach is to contact a wider assortment of doctors’ offices who are familiar with the product and get their review. In order to achieve this, one can simply call the numbers listed on TearLab’s website under “Find a Doctor“. When prompted for location, simply click “view all locations“. A convenient list of all TearLab customers (along with their phone numbers) then appears.

Over the past few weeks, I have contacted dozens of these doctors to ask about their recommendations for conducting a dry eye exam. I did not discuss any interest in TearLab as an investment.

As would be expected, there are a large number of doctors from TearLab’s list who do recommend a tear test. What does come as a surprise though, is that there are also a large number of doctors who have received the test over the course of the past year but no longer offer it, citing lack of need, inaccuracy or difficulty in getting reimbursed.

The doctors who do not recommend TearLab’s test end up recommending the more standard Schirmer test which has been used for many years along with a simple verbal assessment.

In fact, this should not come as a surprise. After more than 5 years, use of TearLab’s test is still the vast exception to the rule. Healthcare sites such as theMayo Clinic do not mention TearLab’s tear osmolarity test at all. Instead they recommend the Schirmer test or simple verbal assessment.

The list of doctors on TearLab’s website can be somewhat difficult to track. During the course of my research, there were a number of additions to the list, representing new doctors who appear to have been added in recent weeks. But there were also some deletions representing doctors who must have either returned or abandoned the test.

TearLab had previously noted that less than 5% of doctors have ever returned a test to TearLab. However this does not account for the units which have simply been discontinued in the practices of eye doctors nor does it account for doctors who have a test unit but see no reason to use it over verbal assessment which is easier and free and is not time consuming for the busy doctors.

The point from this is that the effect of TearLab’s marketing spend often appears to be only in getting some doctors to try the test for an initial and limited period. This clearly leads to a short term rise in revenue, but also a disproportionately large increase in marketing expense. When the revenue is only short lived, this becomes highly problematic. This is likely what we have been seeing over the past 5 quarters and it explains the slight rises in revenues along with much larger increases in the net loss at TearLab. TearLab appears to be constantly in search of new doctors to replace the ones who will not adopt the test after using it.

Looking at TearLab’s product

A heavy marketing budget can drive sales of virtually any product for short periods of time. But ultimately a product will need to justify itself if it is going to sell on its own.

The biggest problem with TearLab’s product is that is just isn’t necessary for the majority of eye doctors. It is certainly true that the product is well liked by specific dry eye specialists (such as those on TearLab’s last earnings call).

The TearLab test allows doctors to quantify tear levels with a numerical score. This is why the true dry eye only specialist practitioners like it. But for the regular eye practitioner, this level of information is simply superfluous and is certainly not worth paying for or taking the extra time from other waiting patients.

In most cases, doctors will simply ask their patients to describe their symptoms and then prescribe corrective measures accordingly. This is not only faster, but it is also free. It also addresses the problem to the satisfaction of the patient.

In some cases, doctors will use the industry standard Schirmer test.

The TearLab test does not offer the majority of practitioners any useable new information. Either a patient has a condition worthy of treatment, or they do not. This is primarily based on level of discomfort. The numeric score does not really add much additional value in a practical setting.

In addition, because the test costs less that $30, there is very little revenue potential for the eye doctor. As a result there is neither an overwhelming financial or medical incentive to use this test. It simply consumes time from office visits along with space on the desk for the TearLab unit.

This is why the test which has been around for more than 5 years still only shows a few million dollars in sales and why these sales only tend to increase when accompanied by a disproportionate marketing spend.

TearLab’s method of dry eye testing has been described as the “new gold standard” for dry eye testing since the early 1990′s – nearly 20 years. It is by no means a new technology waiting for widespread adoption.

In addition, TearLab continues to cite a whopping $1.5 billion market potentialfor the product based on hoped for sales to an estimated 50,000 eye doctors in the US. This massive market potential claim has been consistent for years. Yet after all of this time, new product sales continue to measure in just the hundreds of units for the entire year. The device simply doesn’t sell even after 5 years of marketing.

By this measure, use of TearLab’s test accounts for roughly 2% of applicable dry eye tests per year. And it should be remembered that even this low level is only the result of a very heavy marketing spend.

In effect, the heavy marketing spend has resulted in a small number of doctors trying the test for limited periods of time. But over the past 5 years, there has been no consistent adoption of the test at a meaningful level. While marketing spend may get doctors to try the test, it does not get them to continue using it. As a result, TearLab is on a never ending search for more new trial doctors.

The hiring of Seph Jensen

On October 1st, TearLab announced the hiring of Seph Jensen from Alcon Labs where he had previously served as Head of Surgical Marketing. The announcement quickly sent the stock soaring to as high as $12.33. Since that time, the stock has now retreated by around 15%, giving up most of its gains.

The reason for the quick jump in the share price was obvious. At Alcon Mr. Jensen oversaw $1.4 billion in sales. If tiny TearLab with just a few million in sales could attract this type of talent, then the company must be really headed in the right direction.

Unfortunately there also appears to be a very different explanation for the timing of this hire.

Mr. Jensen was set to start with TearLab on October 31st, just two weeks before earnings are to be announced. It is very likely that the company will report a large earnings miss. Hiring Mr. Jensen will not help to explain the miss which just happened. However, it will allow the company to show shareholders that it is attempting to do something to slow the ever increasing losses.

This view is supported by the fact that Mr. Jensen’s compensation package wasastronomical for such a small company with minimal revenues and ongoing losses. Mr. Jensen will receive a base salary of $370,000 which is moderate. But he will also receive up to an additional 50% of this amount as an annual bonus. He also gets a signing bonus of $250,000. So the initial payments amount to just under $1 million. However, he was also granted 300,000 shares worth of options with a staggering 10 year maturity. The value of these options alone is worth well over $2-3 million alone. For reference, even short dated 1 year at-the-money options on TearLab are worth around $2.50 per share at present.

All in all, the pay package awarded to Mr. Jensen is worth somewhere between $2-4 million at minimum, which is in line with a full quarter’s entire revenue for the entire company. For reference, the entire SG&A expense for Q1 was only $3.9 million. Yet a similar amount is now being awarded to a single executive. The point is that Mr. Jensen should be viewed as an extremely expensive hire for TearLab.

The timing of this very expensive hire coming just before earnings suggests that TearLab is looking to provide investors with some level of comfort in the face of another quarter of ballooning losses. In any event, there is nothing out there to suggest that there has been any change leading into this quarter which will stem the pace of the accelerating consecutive losses from past quarters.


In recent cases, aggregating non-market information helped me accurately predict a significant earnings miss which presaged a quick share price decline of around 30% in several stocks.

Prior to the release of earnings for Francesca and Ignite Restaurant Group, I came to the conclusion that an earnings miss was highly likely in each case. I came to this conclusion based on dozens of phone calls and in person visits which revealed that business was not going to live up to the highly bullish expectations of analysts who cover the stock. The on the ground information I obtained was far more useful that the reports from analysts which simply repeated the views of management.

Making dozens of visits and phone calls is far from a scientific approach, but it has proven to be consistently useful to me.

With TearLab, I have called dozens of eye doctors to ask about their use of the TearLab product. I specifically called the doctors who are currently (or were previously) listed on the TearLab web site as carrying the TearLab test.

While there are naturally a large number of doctors who do carry this test, there are also a surprisingly large number of doctors who had previously used the test but who no longer recommend it to prospective patients. Even among the doctors who do carry it, they do not necessarily state that it is part of their standard dry eye exam. The Schirmer test and verbal assessment tend to remain the standard even among many TearLab customers.

The conclusion from this is that the revenue gains from TearLab’s expensive marketing efforts in some cases end up being very short lived. In many cases the doctors noted that there were several options for evaluating dry eye conditions. But in only a few cases did the doctors immediately tell me that the TearLab solution was a must.

The conclusion I have reached is that TearLab is likely to once again show a very large increase in marketing spend which will be accompanied by revenues which are either flat to down. This is simply due to a relatively underwhelming adoption of the tear test despite the heavy marketing spend. The result will be a loss which is larger than last quarter and which is moderately to significantly larger than expected by the street.

Mr. Jensen will then be given the stage to explain how things are about to change in coming quarters.

I am expecting TearLab to fall to around $8.00-$8.50 following earnings, with potential for further downside in the weeks that follow.

In the meantime, TearLab is a company which sports a $350 million market cap despite cumulative revenues of just $15 million over the past 5 years running. During this time, cumulative losses are now approaching $50 million without a single profit, with losses continuing to grow each quarter.

Disclosure: I am short TEAR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

IRG: Watch for a big earnings miss


Investment thesis

Restaurant stocks have been going through a very tough earnings season. Of the six restaurant groups to have reported so far, five have reported earnings misses. As a result, there has been significant share price weakness following earnings at companies such as Ruby Tuesday’s (RT), Darden Restaurants (DRI) and Dominoes Pizza (DPZ).

Ignite Restaurant Group (IRG) is on deck to report earnings and all signs point to a significant earnings miss. The shares have traded flat for 2 months and could see a decline of around 30%. Given the abundance of data points coming from all angles, this should not come as a surprise to anyone. A large sale by the backing private equity fund could also contribute to further pressure.


Back in August, I made an earnings call just ahead of the reporting date for Francesca Holdings (FRAN). I predicted that the clothing retailer would report weak same store sales and that discounting would continue to pressure margins. My share price target called for a quick 30% drop. Within days, Francesca’s reported their results and they were exactly as predicted. Discounting had accelerated and margins had come under pressure. The shares quickly dropped by 30% to around $17.00.

In fact, these predictions were fairly easy to make. Most of Francesca’s competitors had already reported difficult results and their share prices had tumbled. Many of these competitors even operate in the same malls as Francesca’s such that they suffered from the same weak traffic. I also made it a point to visit in person and call numerous Francesca stores over a period of many weeks so that I had a solid idea about the discounting practices in place during the quarter. My article made all of this clear.

In short, no one should have been surprised by Francesca’s poor results. But the analysts were clearly surprised. They maintained their targets at over $30.00, only lowering them after the big miss. Clearly this helps no one. For some reason, they saw no need to conduct store visits and interviews to support their targets. Likewise, we can see that many investors were also surprised. These investors have just begun filing class action lawsuits against management for not revealing the discounting practices which I described in my article before the miss was reported.

Looking at the restaurant space, we can see a very similar phenomenon unfolding. It is now easy to see that the biggest loser in the near term is going to be Ignite Restaurant Group which is likely to decline by at least 30% following earnings next week. The company is suffering from 3 years of continuously declining sales at its recently acquired Macaroni Grill. These declines are now accelerating rather than reversing. Majority shareholder JH Whitney currently owns 68% of Ignite. However a registration statement filed in July now covers the sale of these shares. The timing for such a sale looks very good for Whitney. But it will certainly put heavy pressure on the share price.

According to its latest 10Q, Ignite is now down to just $1 million in cash. Current liabilities are $106 million vs. current assets of just $40 million. The company now has long term debt of $93 million plus another $13 million due within 12 months. For all of 2013 and 2012, cash from investing activities has more than consumed all cash generated by the business as the company tries to expand its way into profitability. However the company has been losing money in two of the past three quarters. In the one profitable quarter, net income was just $2 million on $118 million in sales.

The company still suffers from multiple weaknesses in internal controls which resulted in the restatement of several years of financial results. Following a plunge in the stock, there are still shareholder lawsuits outstanding. For these reasons, Ignite is among the weakest and most vulnerable of all of the restaurant groups.

As I did with Francesca’s, I recently called and visited numerous Macaroni Grills across two states. Interviews with staff there consistently revealed the existence of significant discounting along with fairly slow traffic over the past 6-10 weeks. The results of these interviews are just one of the reasons that I expect revenues to be flat to down with significant pressure on margins resulting in a noticeable net loss.

A second reason is that we can already see that most of Ignite’s close competitors have been pummeled by poor results. The significant and persistent slowdown in the casual dining space should now be widely known. This was identical to the disappointing results reported by competitors in advance of Francesca’s. Yet many investors ignored these obvious signs and only sold after the disappointment and plunge.

Ruby Tuesday’s is down by 25% in the past few weeks following difficult results and a poor outlook for its turnaround strategy. Darden Restaurants also took a hit of 10-15% following its weak earnings. Darden operates a number of casual dining chains including Red Lobster and Olive Garden.

Shares of BJs Restaurants (BJRI) are down by nearly 30% since its last earnings date. Shares of Del Frisco’s (DFRI) are down by nearly 20%. Shares of Brinker International (EAT) are down by more than 12% since August.

Even Dominos Pizza recently skidded when it missed earnings. Dominoes is at the low end of the price spectrum such that it is usually expected to be more resistant to sector wide slowdowns than many other competitors.

The only competitor to have done well this season has been Wall Street darling Chipotle Mexican Grill (CMG). Chipotle continues to be a very strong stock that seems capable of doing no wrong.

In short, the environment for casual dining stocks has been consistently bad for most direct competitors. It should be noted that the majority of these competitors can often be found within close proximity near the same shopping malls and office complexes. As a result, their sales performances tend to be highly correlated.

Shares of Ignite have been basically flat over the past two months. However, volume has been low. This has been the case despite the fact that the problems at Ignite will have a noticeably greater impact than those of its competitors.

In its last quarterly earnings announcement, Ignite disclosed a loss of $2.5 million. Revenues had jumped to $228 million, but these were driven mostly by its recent acquisition of Romano’s Macaroni Grill in April for $61 million.

By looking deeper, we can see that growth for Ignite’s core business (which excludes the Macaroni acquisition) has basically stagnated. The revenues for Ignite have historically been dominated by its Joe’s Crab Shack chain. In its most recent quarter, revenue from Joe’s increased just 0.7%. Revenue from its Brick House Tavern chain did increase by an impressive 6%. However, given that Brick House now contributes less than 5% of revenue to Ignite (only 16 stores out of over 300), this increase does not move the needle much at all.

In order to combat the revenue stagnation at Joe’s, management plans to open up to seven new Joe’s locations during all of 2013. But obviously these new revenues will come with a fairly substantial startup cost and ramp up time so it will take some time before results are felt. It will also take time to evaluate the real cost-benefit of those new, incremental revenues.

The biggest disappointment this last quarter came from the Macaroni acquisition. Romano’s Macaroni Grill has been struggling for years, reportingsequential declines in each year going back to 2010. The struggles appear to be getting more severe and more expensive.

On its earnings call, management made some troubling revelations:

During the due diligence phase of our acquisition and right up to the February 6, signing of the letter of intent, Macaroni Grill’s comp sales were right around innegative 5%; from February through April 9, when we closed on the business, comp sales deteriorated to a negative 11.5%. While there was no secrete to us that Macaroni Grill sales had been challenged for an extended period of time, the pace of deterioration in the first quarter was significantly greaterthan we had anticipated, and we felt that we needed to act very quickly.

Management noted that it completed a $2 million media buy to attempt to boost sales. This did help to slow the decline moderately. But in the end, Macaroni Grill sales still decreased by 7.4% vs. the prior year. And it should be noted that even this dubious victory still cost management $2 million which went straight to the bottom line.

These observations reveal two significant problems which are going to drive the earnings miss and share price decline at Ignite.

The Macaroni Grill now dominates the equation for Ignite. As of June 30th, there were 186 Macaroni Grills, 134 Joe’s Crab Shacks and just 16 Brick House Taverns.

The decision to substantially lever up to acquire the declining Macaroni Grill is a questionable one. Revenue from the chain was already in decline in each of the past 3 years. It has already declined by nearly 30% in that time. This was prior to the declines in 2013 which now appear to be accelerating.

In 2012, Macaroni lost $6 million on $390 million in sales. Sales are already on track to decline a further 25% from that level this year, following a 10% decline the previous year. Nothing seems to be able to slow the decline.

Management seems to indicate that the problems at Macaroni were larger and more expensive than they had expected. They have also admitted that they were “overconfident” in their ability to make a rapid turnaround of the chain. In effect, we have already been warned of what to expect from management.

The Macaroni restaurants were being staffed very lightly to deal with ongoing declines in business. But new management hopes to ramp up business, and therefore chose to increase headcount by 1,700 jobs. Management noted that:

At any rate a significant investment was made and clearly more than we have planned.

But here is the biggest problem. In order to maintain any type of longer term profitability, Ignite simply must effect a successful turnaround of Macaroni. But turnarounds take lots of time and lots of money before the results are felt or known. It is almost a certainty that the next 2-3 quarters (including this one) are going to be dominated by substantial turnaround expenses from Macaroni. If the turnaround works, we will then likely see results in mid 2014. But until that time there will be lots of pain in advance of the hoped for gain. It also remains to be seen if the surge in expenditures for a few quarters will end up creating a sustained boost to the results of the chain once deep discounting comes to an end.

Management has already committed itself to substantial fixed costs by adding these 1,700 new jobs. Many of the hires would not have been in place for the full length of last quarter. As a result, the expensive effect of these hires on net income will not be fully felt until this quarter. Management will also continue to spend heavily on media buys and the advertising budget. But as we saw last quarter, even spending $2 million did not end up increasing sales. It only slowed the rate of decline.

Perhaps the largest negative impact will come from the discounting of customer bills that is necessary in order to attempt to lure customers in to the stores. We can see from their website that there are multiple promotions ongoing which promise discounts to customers. Sales of alcohol are a leading profit driver for these chains. But Macaroni is now offering half priced wine priced at just $2.75 to attract customers. Visitors are offered $5 off for signing up for the mailing list. Group parties who pre-book get 15% off. Each time I ate at Macaroni Grill, the staff gave me discount coupons to come back again and get more taken off of my bill. It is clear that Macaroni Grill is trying to increase absolute traffic by cutting prices wherever possible.

According to the wait staff I spoke with, a new line of bigger promotions will be rolled out this weekend. Those who wish to gauge the impact of future discounts should check on Ignite’s website once these promotions are announced over the weekend.

But we can see from past promotions that these discounts have previously failed to boost sales. Coupon histories can still be found online which show that during late 2012 and early 2013 Macaroni Grill was providing half priced food and “buy one get one free” offers. These offers were made at precisely the time that sales for Macaroni Grill were showing their largest declines.

These offers are a devils bargain for restaurants. They often end up losing money on them, but they feel that they have no other choice if they want to stimulate the nominal level of sales and traffic.

During the most recent quarter, the Macaroni Grill returned to “buy one get one free” promotions. “Happy hour” with loss leading specials now lasts as long as 5 hours. This leaves very few prime time hours during which to offset those losses.

What we will almost certainly see at earnings is that the heavy spending and discounting will help to move the needle on revenues, but it will come at an enormous cost to margins and will contribute to a large net loss.

Given the accelerated discounting, it is almost guaranteed that the net loss in the current quarter will greatly exceed the $2.5 million from last quarter. In fact, the loss could even significantly exceed the $8 million loss reported in December of 2012.

Heavy discounting to stimulate declining traffic was exactly what we saw in the retail space with Francesca’s which led to its recent 30% plunge. The malaise is also identical to what we saw with the turnaround strategy at Ruby Tuesday’s. By now, the short term results of this type of strategy should be predictable. Investors will be forced to tolerate near term losses in the hopes that a rebound will happen in several quarters. But in fact, most investors will tolerate no such thing. They will tend to sell their shares now and re-evaluate once the results of the turnaround strategy become better understood in a few quarters.

Part of the problem in the restaurant industry is that these discounts have been absolutely pervasive this year. When every restaurant out there is offering deep discounts, it does little to help the business of any one of them. Instead, it just means that deep discounts are needed just to lure customers away from the other deep discounting restaurants. For those who are interested, here is just one of dozens of coupon lists where consumers can get deep discounts on meals from Applebee’s, PF Changs, Sonic, Cheesecake Factory, Olive Garden, Outback, Chili’s and on and on.

The conclusion is that many restaurants are now being forced to issue coupons and discounts. If they do not, customers will simply go to other chains which have large discounts. And when one restaurant stops discounting, consumers will just switch to the others that do. In the current environment, no one should be paying anything close to full price for meals in casual dining chains.

Share of Ruby Tuesday’s fell by 16% upon earnings. Stifel Nicholas describedthe situation for the brand in a research report as follows (readers should note that these comments appear to apply quite precisely to Ignite and other brands as well).

The persistent casual-dining sales slowdown has presented a more-than-challenging environment for an in-turnaround concept such as Ruby Tuesday that seeks to re-introduce consumers to its brand,” he said. “We continue to believe that mass-casual family dining names such as Ruby Tuesday willcontinue to underperform until the casual-dining sales softness that haspersisted throughout September shows signs of reversal.

So we now have the observations from above, along with statements from management and then comments from analysts. All of these consistently point to a very challenging environment for the comps and especially for turnaround stories like Ignite.

After viewing these similar assessments, no one has any excuse whatsoever to be surprised at a substantial disappointment from Ignite next week.

One question now is whether or not private equity firm JH Whitney intends to stick around for several more quarters to see if this acquisition can actually be turned around. The recent registration statement was filed in July. This was just a few months after the troubled Macaroni acquisition and just before the recent earnings disappointment was made known to investors. Whitney has two board seats at Ignite, so it should be fairly plugged in to the latest developments.

Whitney has already done well with this investment. The firm sold stock in the IPO at $14.00 and also received an $80 million cash dividend payment from Ignite before the IPO.

The acquisition of Macaroni has some interesting details. The target was acquired from Golden Gate Capital for $61 million in cash. Whitney and Golden Gate have some intertwined executive histories and they have also worked together in the past, most notably in taking Herbalife (HLF) private and then selling the company for a substantial profit.

The Los Angeles Times notes that

Whitney and San Francisco-based investment firm Golden Gate Capital Inc. acquired Herbalife for $700 million in 2002, putting up $176 million of their own money.

Shortly after the firm went public again in late 2004, it paid Whitney andGolden Gatemore than $110 million in dividends, filings show.

After the value of the shares more than doubled in 2005, Whitney sold a large portion of its holdings, raising $233 million.

In the case of Ignite, JH Whitney’s rush to get liquidity in the stock means it may have come public a bit before it actually was ready to be an answerable public company.

Ignite still lists 4 material weaknesses in its internal accounting controls. Previous weaknesses resulted in Ignite restating 3 years worth of financial statements just after the company came public. This caused a 25% plunge in the share price and resulted in lawsuits against the company and their underwriter for making material misstatements in the IPO.

It is somewhat surprising that the weaknesses have still not been remedied even 15 months after the IPO. Instead, the company has taken a JOBS Act exemption which allows it to continue operating with material weaknesses in internal controls. Under normal circumstances, this would be bad enough. But with Ignite trying to integrate a major acquisition of a very challenged and sprawling brand, this is almost a perfect formula for yet another restatement.


Right now is a great time for consumers who wish to eat out cheaply. Restaurants are aggressively competing on price to combat a sector-wide slowdown in traffic. These restaurants have demonstrated that they are more than willing to incur substantial losses in an attempt to maintain traffic. We have already seen earnings disappointments in 5 out of 6 reporting restaurants. Share prices have dropped accordingly. So what turns out to be great for consumers is in fact quite challenging to these restaurant groups.

Ignite is a far weaker restaurant group than most of its peers. The company’s balance sheet is very weak with just $1 million in cash and a deep current account deficit. The company has reported losses in two of the past three quarters. Last quarter began to feel the impact of the continued slowdown in the Macaroni Grill. Efforts to stem the decline are already proving to be very expensive but with minimal results. Management clearly has its hands very full in trying to integrate this large acquisition, such that ineffective internal controls have still not been remedied after 15 months.

Ignite and several analysts have already given us a very clear view about what to expect this quarter in terms of the restaurant slowdown and the impact on revenues and earnings. By trying to launch an expensive turnaround during a restaurant slowdown, Ignite is likely to exacerbate these difficulties substantially.

As a result, no one should be even remotely surprised when Ignite reports a much larger loss than last quarter. Shares should be expected to correct by around 30% to around $11-12 following earnings.

Disclosure: I am short IRG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.


Kandi: The truth hurts


As I mentioned in my last article, Kandi Technologies (KNDI) recently soared from around $5.00 to a lifetime high of $9.20 in the span of just 8 days. Just like in June, this monumental lift off came as the result of a single press release from Kandi and several promotional articles from individuals who are long the stock.

As has been the case in every instance in Kandi’s past, these gains have not held. Kandi has now declined 5 days in a row to $7.10, a very rapid decline of 23% from that recent high just days ago. Yesterday the stock closed near the day’s low of $7.02. If this rate of decline continues, then Kandi will be below $5.50 by the end of next week.

It is clear that many investors who are active in Kandi have derived the vast majority of their information from a series of highly bullish articles and from a private Yahoo message board which was created specifically by those who promote Kandi. The information presented seems to gain credibility because it appears to come from multiple independent sources.

Unfortunately, much of the information which has been disseminated on Kandi (and which has made the price soar) is 100% factually incorrect. Once again, as investors come to realize that they have invested based on inaccurate information, the stock will certainly erase its gains and go back below $5.00 once again.

The most recent example was the article published by Harris Goldman, entitled “As China Goes, So Goes Kandi”. His article has since been removed from Seeking Alpha. Fortunately, references to his comments can still be found in my last article.

The Goldman article does not appear to be the only bull piece that contains substantial inaccuracies which have boosted the share price. Going forward, I will be releasing a series of corrections to a number of very significant factual inaccuracies which have boosted Kandi’s share price in recent articles. This work is already in progress.

Unfortunately I did not save a PDF hard copy of the Goldman article, so we do not have a full permanent record of the line by line comments. However, I have now downloaded and saved copies of all remaining articles relating to Kandi so as to preserve a permanent record in the future

To be specific, Kandi bulls have misled readers about numerous things including: Kandi’s manufacturing capabilities, Kandi’s competitors, the current market demand for EVs in China and the impact of government subsidies.

On the day before the publication of the Goldman article, Kandi had traded as low as $6.60. On the day of his article, the stock rose as high as $8.60. Within 2 days, the stock hit its all time high of $9.20. This was a rise of nearly 40% in just 2 days, based off of a single article.

There is a very clear reason why the Goldman article (as with some of the others) moved the stock. Mr. Goldman made it clear that Kandi is the ONLY company which has mass capabilities and that NO ONE other than Kandi in China can compete http://gulfcoastretirement.org/admin/generic/ on this type of price and volume. Mr. Goldman had incorrectly noted that Kandi already has capacity of 100,000 vehicles which will increase to 300,000.

If any of this were true, Kandi would have certainly deserved a bump up in its share price. In fact, it might actually lend some credence to the notion that Kandi is “the Tesla of China“. Unfortunately none of these statements are correct.

Fact: The EV market in China suffers from too much capacity and too little demand

The Kandi bulls have promoted the view that Kandi is the ONLY competitor in China and that demand is so strong that Kandi will be able to sell everything it can produce.

These statements are both 100% incorrect. There are hundreds of EV manufacturers in China. These are not tiny no-name companies. And they already have greater manufacturing capacity than Kandi. In addition, the prices for their EVs can be seen to be lower than Kandi’s. Their operational specs are basically identical.

In my last article, I included a link to a search on China’s Alibaba portal (in English) which showed these hundreds of competitors. But clearly from the angry emails and comments that have been written, we can see that almost no one even bothered to open the links and read for themselves. Instead, a small number of vocal Kandi bulls simply rejected my findings without even reading them.

I would strongly suggest that readers not simply rely on an interpretation of this list from either me (I am short Kandi) or from Art Porcari (Art is long Kandi). Instead, I would suggest that readers take a small amount of time to evaluate these competitors themselves.

What they will see is that there are many producers of roadworthy and street legal vehicles which derive the vast majority of their sales from entirely within China. Period.

Below is a very brief and partial selection from my Alibaba list, along with their delivery capacities. As we can see, there are numerous manufacturers in China who have greater manufacturing capacities AND lower prices than Kandi. I have included the link to the individual vehicle listings so that viewers can see for themselves that these are mostly identical to Kandi’s cars. Beyond these, there are many more.


Name Annual Capacity City Price
Zhangjiagang Haowin New Energy Technology Co. 120,000 Shanghai Inquire at Alibaba
Jinan Qingong International Trade Co. 104,000 Qingdao $6,400-$8,600
Guangfeng Xiaoni Trading Im. And Ex. Co. 96,000 Tianjin $3,500-$4000
Guangdong Yatian Industrial Co. 72,000 Guangzhou $7,000-$7,650
Shandong Bidewen Power Technology Co. 60,000 Qingdao Inquire at Alibaba
Shangdog Shifeng Co. 50,000 Qingdao Inquire at Alibaba
Shandong Wina Green Power Co. 50,000 Shangdong Inquire at Alibaba
Jinan Allied International Trading Co. 30,000 Qingdao $8,000-$9,000

Until my recent article, Kandi’s promoters continued to make the claim that Kandi is the ONLY such manufacturer in China simply because US investors did not know otherwise. Of the EV makers that sell in China almost none of these companies trade on US stock exchanges. The only ones that do (such as BYD and Geely) tend to be Hong Kong listed and trade on the pink sheets. The EV makers in China typically market themselves only in China. As a result, the vast majority of US investors are entirely unaware of the presence of numerous competitors.

But the Kandi promoters have repeatedly claimed to have performed countless hours of “due diligence” over the span of multiple years. The words “due diligence” appear numerous times throughout their articles as assurance to readers about the thoroughness of their work.

Yet the information on competitors is easy to find for anyone who looks.

Author Tom Konrad (who was long the stock) lost a number of friends when he expressed some caution on Kandi. This was true even though he maintained a (reduced) position as a long. Unlike some of the more unrepentant bulls, Tom made sure to highlight the fact that Kandi does have competition from some of the largest EV manufacturers in China. Tom specifically highlighted Chery Automotive, Shandong Shifeng Group, and Hebei Yu Jie Ma. Tom recently noted that he sold his Kandi stock as soon as it hit $7.00.

Point #1: It is inconceivable that such thorough “due diligence” from the Kandi perma-bulls would have failed to uncover the existence of hundreds of nearly identical competitors who have massive production capacity in China. Yet until my last article, these facts were denied.

Point #2: The claim that Kandi is somehow unique (“the Tesla of China”) is therefore based on information that is 100% inaccurate. Yet this inaccurate claim has now been made dozens of times.

Clearly the points above illustrate that there supply of EVs is far greater in China than the Kandi bulls have stated. But of equal importance, it is also the case that demand is far lower than the bulls have stated.

We can see that many of the bull arguments posted include the fact that China has targeted 500,000 EVs by 2015 and 5 million by 2020. Some have cited the “10 Cities and 1,000 Vehicles” program which has been promoting EVs via subsidies in 25 cities (including HangZhou). This program which includes subsidies has been in place since 2009.

The Kandi promoters have emphasized these impressive facts to indicate that there will be tremendous demand for EVs in China. This information, coupled with the incorrect information that only Kandi can supply them, has led investors to the conclusion that Kandi will soon be worth a tremendous fortune. People who read the bullish articles on these subjects, but who fail to do their own research, are then fully convinced. When the articles come from multiple authors, it lends even greater credibility.

But the reality for Kandi and for the EV market in China is far different than what is being consistently preached by the Kandi promoters. In fact, the reality is entirely consistent with the results we see from Kandi’s financial statements. It is also consistent with the share price reactions we have seen from the few Chinese EV makers who trade on foreign exchanges. It is also quite consistent with the unanimous view expressed by independent media channels and Chinese automotive experts.

The only people telling us otherwise are a small number of individuals who happen to own Kandi stock.

In July of 2013 (just 3 months ago), the WorldWatch institute put out a research piece entitled: “China’s Electric Vehicle Development Failing to Meet Ambitious Targets”

The report states clearly that

Although these ambitious targets are developed and supported by the central government, they seem overly optimistic and unattainable given the current situation. According to the China Association of Automobile Manufacturers, only about 20,000 new energy vehicles (EVs, hybrid-electric vehicles (HEVs), and PHEVs combined) were sold in 2011 and 2012, meeting only 4 percent of the 2015 target.

The current reality in China is that people aren’t buying electric vehicles simply because they don’t want them. Clearly some of this is related to price. The bulls have stated clearly that the recently announced subsidies will help that.

But the recent subsidies were actually a renewal of subsidies that have been in place for years. During that time, and despite the subsidies, EV sales have been miniscule.

According to a report from McKinsey.

Government-sponsored subsidies have failed to stimulate consumer demand. For example, while EV buyers in Shenzhen were offered some of the highest subsidies in the country (e.g. RMB 120,000 per vehicle for BEV passenger cars), automakers sold only about 600 BEVs there by 2011.

Beijing based Jack Perkowski has over two decades of experience as an expert in China’s auto industry. He formerly ran a joint venture which invested over $100 million in Chinese auto parts JVs. In June 2013, Mr. Perkowski wrote an article in Forbes entitled “The Reality Of Electric Cars In China“.

He notes that:

recent meetings that we have had with most of China’s local car assemblers confirm that none are counting on electric vehicles for any meaningful amount of growth anytime soon…. BYD , the poster child for electric vehicles in China, is also de-emphasizing electric vehicles. … Due to their intellectual appeal, hype for electric vehicles has always gotten ahead of the realities of market demand. In China, this is once again proving to be true.

Quartz.com just put out an article last week in response to the latest Chinese subsidy news entitled “Even the Chinese government can’t command progress on electric cars“.

According to Quartz:

Beijing hasn’t given up on the race to dominate electric cars. But scant sales have turned China away from focusing on wheels on the road right now….About three years ago, the US and China both announced ambitious aims to capture the global electric car market by putting, respectively, 1 million and 500,000 electrified vehicles on their roads by 2015. Today, neither country is on track to reach these numbers-instead, the US has 130,000 electrics andChina a paltry 40,000…. But analysts doubt the renewed subsidies will finally trigger a buying binge

Those who are reading this article can feel free to completely disregard my views. After all, I am short the stock and therefore biased. However…

Point #3 : US investors need to ask themselves why so many independent experts such as Bloomberg, McKinsey, WorldWatch, Perkowski and Quartz, are all so bearish on the EV market in China. Likewise, they need to ask themselves why the only parties who are wildly bullish happen to be a small handful of investors who also happen to own stock in Kandi ?

There are a number of very common sense and logical reasons why EV sales continue to be so poor in China. For these same reasons, most experts do not see a substantial rise in EV sales any time soon.

Because these EV makers have competed on price, the quality of the vehicles is undeniably very low. This should be visible from the pictures of Kandi’s cars which are available on line. The dozens of competing low speed, low priced vehicles are also nearly identical.

The drive train for an electric vehicle is actually fairly pricey. Yet the cost of the whole vehicle is only around $10,000. Readers need to use their common sense to decide if one can actually manufacture a high quality automobile for just a few thousand dollars.

I recently test drove a Kandi vehicle which sold for around $10,000. It was not horrible, but quality was clearly an issue. When I drove it, the glove box kept falling open. The windows are old fashioned crank style windows which do not open easily. The seats vibrate a lot. There is a loud whirring noise when driving. It is not the end of the world. But it is also not a vehicle that many people would likely choose to drive – at any price – if they have any alternative.

But keep in mind that Art Porcari has also test driven a Kandi car and he continues to tell us all that Kandi is set for near term greatness. He is also long the stock and stands to benefit from the rise in its share price.

Kandi, Geely and many other manufacturers have had EVs on the market for years. The “10 Cities” program has been promoting EVs since 2009. Yet in the past two years, a grand total of only 20,000-40,000 vehicles has been sold – by all manufacturers combined ! This is during a time when the subsidies werealready in effect.

The reason why Kandi itself only sells a few hundred of these EVs is because most people are not interested in driving such a low end vehicle. We have already seen that cutting the price does not really boost sales when it is a product that people just don’t want. People need to keep in mind that the vehicles made by Kandi have absolutely nothing in common with a high end vehicle like Tesla.

A separate reason is far more practical. Anyone who has lived in China knows that parking in any major city in China is very similar to trying to park in the middle of Manhattan – or worse. It is extremely difficult and absurdly expensive. This should be intuitive when one considers that the population of Beijing is over 20 million. The population of Shanghai is over 40 million. That means that the population of Shanghai is greater than the entire state of California – crammed into a single city. It is greater than the population of New York, Los Angeles, Chicago, San Francisco Boston and Seattle – combined ! And that is just one city. Likewise, China has dozens of cities with populations greater than 5 million.

What is the point ? The point is that people who can’t afford $10,000 for a car can also not afford to drive or park a car at any price in China. Many US investors are clearly unaware that in a country of 1.6 billion people, the vast majority of people do not live in single family homes with an attached garage. They live in large high rise buildings which do not come with their own garage space. If you gave them an EV for free, they would still have no place to park it. Nowhere !

Those who can afford a home with a garage in China are typically not inclined to buy a noisy low speed vehicle with crank windows and no amenities. Those who cannot afford a garage have no interest in owning a car at all.

These notions are not my opinions. They are facts which are frequently expressed in the Chinese media. One example can be found in an article entitled:

Dying for a Spot: China’s car ownership growth is driving a national parking space shortage

Individual readers can come up with their own explanations for the very poor EV sales. But the fact remains that there has been virtually no demand for low priced, low speed EVs in China from consumers.

I am not saying that Kandi will not sell any vehicles. I am saying the best case scenario is dramatically less than what the Kandi bulls are promoting. It is clear that Kandi and the dozens of other major EV makers will hope to sell the low cost, low speed vehicles to taxi and other public transportation systems.

WorldWatch agrees with this, saying:

As a result, more than 80 percent of the so-called “energy-saving and new-energy vehicles” (EVs, HEVs, PHEVs, fuel cell vehicles, and other energy-saving conventional vehicles)across the 25 pilot cities were purchased for public transportation service rather than private use, showing a weak market demand for these types of vehicles among private consumers.

Likewise, McKinsey shares this view, stating:

In addition, government subsidies and incentive policies have proven to be far more effective at stimulating the purchase of EVs for public fleets than they have been at stimulating private consumer demand.

The HangZhou agreement with Kandi was announced in 2012 but material sales have yet to occur. At some point in time, if material sales actually materialize, this will be a good start for Kandi. Kandi may therefore be able to sell several thousand vehicles over the next few years. But this is categorically different than the predictions of $2 billion in sales from Mr. Goldman or even $100 million in near term sales from Mr. Porcari.

While there may ultimately be demand for even more LSVs from various taxi and public transport companies across China, it must also be remembered that there are potentially hundreds of companies – with massive over capacity in production – who are vying for this same business.

Point #4: Kandi bulls have projected massive sales figures by simply assuming that demand is there for 100% of what Kandi can produce. Yet despite ongoing subsidies and incentives for the past 3 years, only 20,000-40,000 EVs have been sold across all of China by all EV makers combined.

Question: Did Kandi move due to “news” or hype ?

Whenever there is any news which applies to EVs in China, Kandi’s promoters begin trumpeting the development as being a massive catalyst for Kandi’s near term profits and share price. So far this gambit has worked well, and the share price shows sharp jumps (but which only last for a few days).

We saw this sort of hype in June when Kandi announced its inclusion on the MIIT approved vehicle list. The problem with this news is that it applied to hundreds of other vehicle manufacturers and thousands of other models. No other EV manufacturer saw their stock surge even though they were included on this list too. In fact, no one else even bothered to announce this “news” because it was a non-event. Yet Kandi’s share price quickly doubled to $8.50. It was also interesting that the official list had been published in China weeks before Kandi chose to announce it for themselves. Kandi delayed the promotion of this news until it was much closer to issuing $26 million in stock.

This latest “news” in September was that China had codified its subsidies for EVs. Again, this was trumpeted as a major and transformational development for Kandi and the stock soared to $9.20 on the back of Mr. Goldman’s article. As was the case in June, this news was released over a week earlier. Kandi did not put out a pres release on the subject until immediately before filing a S3 covering the sale of over 1 million warrants which would raise $5 million for Kandi.

As was the case in June, the September news applied to the entire EV market in China. Of greater importance is the fact that these were not new subsidies at all, but instead were just a renewal of past subsides. And in sharp contrast to the analysis from Kandi promoters (who own Kandi stock), independent media suggested that the news was not so great.

So what does the independent media have to say about the latest “news” ?

Bloomberg offered the following commentary on September 17th, following the announcement of the subsidies:

The new policy is basically the same as the previous one and doesn’t really address the underlying problems,” Han Weiqi, an analyst with CSC International Holdings Ltd. in Shanghai, said yesterday in a phone interview. “Unless there are follow-up measures to step up support for hybrids, today’s policy is not expected to spur the EV market.

A new subsidy plan has been long awaited,” Ole Hui, Hong Kong-based analyst at Mizuho Financial Group Inc. (8411), wrote in a report today. “This new plans seems less aggressive than earlier targets.

So how did the share prices of other EV makers respond to the news ? They certainly did not shoot up by 50% like Kandi did. Following the release of the subsidy news, Bloomberg noted that:

BYD Co. (1211), the maker of electric vehicles that counts Warren Buffett‘sBerkshire Hathaway Inc. (BRK/A) as a shareholder, fell as much as 3 percent as of 11:12 a.m. in Hong Kong trading.SAIC Motor Corp. (600104), which began offering its Roewe E50 electric car in November, slid as much as 1.4 percent in Shanghai.

But for the Kandi bulls, the recent “news” of Chinese subsidies was to be transformational and would send Kandi into the stratosphere.

What is the point of this ? The point is that the facts being conveyed by a small number of vocal Kandi bulls (who happen to own the stock) is wildly at odds with view being expressed by the mainstream media, including Bloomberg, McKinsey, WorldWatch and many others. The movements in the share prices of other EV makers seems to agree with Bloomberg. Only Kandi has soared to new highs. But this sharp rise has been based on the analysis and interpretation of this small group of individuals who profit from gains in Kandi’s stock.

Point #5: Even when news has been neutral or negative, Kandi bulls have used any mention of EVs in China to proclaim a new, transformational tipping point for the stock. This has consistently been at odds with the views of independent media sources and the share price reactions of the few publicly traded Chinese EV makers.


There are several realities that we must deal with in looking at Kandi.

The first reality: there are a large number of investors who simply do not even care if Kandi has a bright and legitimate future or not. They simply know that these hyper bullish articles have consistently been able to provide the stock with a sharp (but brief) boost. They are happy to buy and make a quick and easy profit. But they have no intention of waiting around to see if the hype is real. As a result, they quickly sell to lock in quick profits. This is why Kandi has repeatedly given up its gains on each surge in 2013.

It can be easily seen on comments below articles and on message boards that various investors are now counting much more on a continuing stream of bullish articles to pump up the share price than they are on any actual progress from Kandi itself. This is a very bad sign for any stock.

The second reality: The information which has been used to promote Kandi’s share price has often been 100% incorrect. Kandi is NOT the ONLY supplier of EVs in China, there are hundreds of identical offerings. Demand for EVs is not astronomical. It is not even merely substantial. The extremely and persistently low levels of demand have been cause for concern in various independent articles and industry reports. Likewise, the latest “news” regarding the EV industry and subsidies in China has been negative and has seen share prices of other Chinese EV makers fall rather than skyrocket. Analysis by independent media sources (who do not happen to own Kandi stock) have been unanimous on this front.

But because the numerous other EV competitors in China are unknown in the US, many US investors have come to believe that this inaccurate information is true. The fact that multiple writers have been posting very similar (but inaccurate) information has caused many investors to give this information even greater credence.

The fact remains that many investors who have bid up the price of Kandi by 50-100% have done so based on information which is verifiably 100% incorrect. As they come to appreciate this, the stock will almost certainly correct to below $5.00, from where it began.

The third reality: Kandi bears all the hallmarks of a classic stock promotion. A small number of investors produce well timed and coordinated articles designed to generate maximum enthusiasm for the stock. Much of the information is inaccurate. The promotion is then coordinated with organized buying to elevate the price.

The promoters of Kandi have then set very lofty share price targets which are often several hundred percent above the current level.

But readers need to ask themselves this: if Kandi is destined to rise to $30-50 in the near future, then why is there such a desperate need to continue pumping the stock when it gets down to $5.00 ? Why is there such a desperate need to defend the stock as soon as it falls by as little as 50 cents ?

If the share price were really headed to $30-50, then the right strategy would be to simply turn off ones computer and ignore the stock for the next 6-12 months. One could simply ignore arguments like mine because they would truly have no impact on the share price 6 months from now. These gyrations would be just random noise over the period of a few months.

The determination by the promoters to get the share price up basically tells us that they do not have the confidence in Kandi that they claim. Their rabid concern over the share price can only be explained by assuming that they are looking to sell in the near term and at prices not far above current levels.

Clearly the only thing that would really propel Kandi to such lofty levels would be actual success on the commercial front. But the steady stream of articles designed to pump up the share price has continued anyway. And now, we are told to expect a full promotional video produced by a professionally hired video production team. Once again, if the stock is inevitably headed for $30, then such a promo video would not be necessary. Nor would it have any marginal impact relative to the triple digit gains which are expected.

The good news is that for those who really believe that Kandi is truly destined for near term greatness, detailed findings like these really don’t matter. Investors who feel this way should simply disregard this article and not even watch the share price.

Disclosure: I am short KNDI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Biolase plunges on liquidity concerns

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On Wednesday August 7th, Biolase Inc (BIOLannounced Q2 results. The company missed analyst estimates by 2 cents and updated investors with guidance at the lower end of previously given ranges.

Missing earnings is never a good thing. But as earnings misses go, this one was certainly not catastrophic. Despite the moderate nature of the miss, shares of Biolase began to plunge in the days that followed. The shares have now fallen by 50% in the week since earnings. The shares have not traded up on a single day since earnings. Clearly something bigger is going on.

(click to enlarge)

As shown below, further steep declines in Biolase are highly likely in the next few days due to the need to issue a large amount of equity, regardless of the price.

The company’s $30 million S3 registration statement should be effective within days, at which time the offering can proceed. Biolase is in a position where it simply must complete an offering, such that even if the price falls to $1.00 or below, the offering must still proceed.

What has happened is that details given in the 10Q and the earnings call have revealed that Biolase is now in the middle of a near term solvency crisis. Yesterday, as the stock was hitting $1.80 (down 50% since earnings), Biolase put out a brief press release, repeating what it had already stated in the recent 10Q, that Comerica Bank had waived Biolase’s non-compliance until September. But, as expected, the stock price was not cheered and continued to fall 7% further that day. Following the press release, Biolase closed at $1.81, a new low for the year.

As confirmed in the press release, Biolase is now in violation of its bank covenants. It has around 19 more trading days in which to rectify this situation before the Comerica deadline. Biolase has already given weak guidance for the remainder of the year such that any turnaround in financial performance will not be able to repair the situation with Comerica.

The only way for Biolase to repair the situation with its lender will be to issue a substantial amount of stock at whatever price the market will bear within the next 19 trading days. Biolase knew that this situation was coming, so they filed a $30 million S3 registration statement just a few days before earnings. Had the S3 been effective, Biolase would presumably have already issued stock immediately.

On the conference call Biolase specifically highlighted the filing of the S3 as its source of liquidity when discussing its low cash balance and the situation with its credit facility. As a result, there should be very little uncertainty with respect to the company’s intentions about issuing stock.

The $30 million S3 was filed on July 26th. Yesterday (after the close) Biolase filed the amended S3 which included reference to the latest 10Q and the latest share price. It confirmed a maximum size of $30 million. There were no other changes of substance. As a result, the S3 should be effective within a matter of days.

At that time Biolase will need to issue stock almost immediately. The biggest threat to Biolase is now that the stock will continue to fall before the offering can be completed. Either way, once the S3 is effective, we can expect a very quick offering by Biolase which will likely come with a discount of at least 20%. Given the distressed nature of the company at present, the offering will likely require additional issuance of warrants.

The market has already figured this out. This is the reason for the continuing plunge in the share price.

It doesn’t matter where the stock appears to stabilize, investors always become aware that a further drop is guaranteed because of the need to issue stock at any price. Hence, the selling continues.

Biolase has not risen on a single day since releasing earnings.

Certainly Brecken Capital saw this coming. The fund had previously owned around 9% of Biolase but began selling down its holdings following disappointing Q1 results. As soon as the S3 was filed, Brecken reduced its stake to exactly 4.99% which allows it to sell further without making any disclosures. Had Brecken attempted to dump larger amounts of stock earlier, the reported sales would have spooked other investors making additional sales difficult for Brecken. Instead, Brecken conducted a very smart stealth exit from Biolase.

Everyone knows that an offering is coming. Everyone also knows that the discount on the offering will be very large due to Biolase’s distressed financial condition. This has created a viscous circle of selling.

Now there is the additional problem that as Biolase’s share price continues to fall, the market cap is now getting dangerously low. There becomes the very real risk that Biolase will be forced to issue substantial amounts of stock at prices below $1.00. But at those prices, Biolase would struggle to raise a sufficient amount of money to satisfy the bank while continuing to run its business.

On its recent conference call, Biolase management disclosed that revenues were 7-10% lower than internal goals for the quarter. Gross margin fell from 55% to 39%. The net loss grew to $2.6 million. Cash balance has now fallen to just $2 million and management disclosed that the company will not generate cash flow for the year.

Total stockholders equity has now fallen to just $8 million. Meanwhile Biolase owes at least $6 million to Comerica.

According to the credit agreements, Comerica has the right to declare all amount outstanding to be immediately repayable in the event of a default. Biolase is now in default due to its failure to maintain $500,000 of EBITDA. But clearly Biolase does not have the money to repay Comerica.

As a result, Comerica had no choice but to waive the default for Biolase for several weeks. As an initial move, Comerica did begin curtailing credit to Biolase to restrict any future borrowing. The credit facility has just beenreduced from $10 million to $7.5 million.

Often times there are creative ways for distressed companies to gain some additional traction with their lenders during hard times. Unfortunately, Biolase appears to have already exhausted all of these extreme measures.

The receivables have already been placed in a “lock box“, such that Biolase cannot touch any of the proceeds from these sales until Comerica first receives the money and services the debt.

Next, substantially all of the assets of Biolase have been pledged. This is not just assets which are presently owned, but also against any assets which may be acquired in the future.

As disclosed by Biolase

Lockbox arrangements under the revolving bank facilities provide that substantially all of the income generated is deposited directly into lockbox accounts and then swept into cash management accounts for the benefit of Comerica Bank. Cash is disbursed from Comerica Bank to the Company only after payment of the applicable debt service and principal. At June 30, 2013 and December 31, 2012, there were no restricted cash amounts. The Company’s obligations are generally secured by substantially all of the Company’s assets now owned or hereinafter acquired.

Also disclosed was that Biolase issued 80,000 warrants to Comerica with a strike price of $2.00. This warrant would have been an incentive payment from Biolase to Comerica. The warrant was issued in 2012 and was fully exercised by Comerica in 1Q2013. The issuance of stock warrants to maintain a lending relationship with a bank is a very unique occurrence. But the issue is that stock and warrants are the only currency that Biolase can currently make use of.

What we can see is that anything resembling an asset has already been given to the bank as security. There is nothing left to give. When assets ran out, Biolase began giving the bank warrants on its stock. But with the share price is a tailspin below $2.00, there is little value left to be given to the bank.

As a result, Biolase has no choice but to issue equity at any price, regardless of how low.

How did we get here ?

Biolase has been in business for nearly 20 years but has consistently failed to generate profits.

After years of consistent losses, investors and analysts were cheered in March, when Biolase released Q4 results. In Q4 Biolase reported a rise in revenue and a very rare profit. The hope was that after decades, Biolase might finally be turning the corner. The shares rose to a multi year high of over $6.00, up from just $1.50 last year.

This hope was darkened when a disappointing Q1 was reported (including a resumption of net losses and a dangerous drop in cash). The shares quickly fell to below $4.00.

Q2 results the smashed all hopes completely. It was another money losing quarter along with discouraging guidance. Within days the stock was trading below $2.00 again.

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The ongoing net losses have been a notable drain on cash. Biolase has not shown any positive cash flow from operations in the past 4 years. The only source of cash which has carried Biolase through up until now has been the proceeds of its $18 million equity offering competed two years ago.

Over the course of the past year, there have been numerous headlines detailing Biolase’s progress with various patent and partnership initiatives. This lasers for Ear, Nose and Throat (“ENT”), eye conditions such asGlaucoma, and the NewTom oral imaging product.

It may be the case that over coming years, one or more of these products might start to become a meaningful contributor to recurring revenue. However investors have largely learned to tune out these announcements until they produce real results.

As shown in its recent presentation, Biolase already has 352 patents on various new products issued and pending. Over 70% of these are related to WaterLase technology. Yet despite the progress on hundreds of patents over the past few years, there has been very little translation into recurring revenues. This is why investors have largely tuned out the similar announcements during 2013.

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Biolase has already put out guidance that it hopes to achieve approximately $68 million in revenues for 2013. This is the low end of what had previously been announced. This would be an improvement over 2012, but would still only put Biolase back on track with the revenues it had achieved in 2006. Biolase has not given guidance for when we would expect to see quarterly profits instead of quarterly losses.

When explaining the difficult Q2 results, Biolase offered a laundry list ofexcuses, including:

- disappointments in Germany

- delivery delays from Europe

- flooding in Canada

- non approval from Health Canada of Epic 10

- generic problems with Obama care

- rising interest rates

Basically, anything that could possibly go badly did go badly. But this has been consistent for years now. This was not an unusual quarter for Biolase.

In reality, management used incredibly poor judgment in waiting to issue equity. In Q1 the cash balance was already down to $1 million, such that the need for an offering should have been very clear. The share price had traded as high as $6.00, meaning that over $20 million could have been raised at a very attractive price. This would have given Biolase complete freedom to run its business for the next year or two without any cash constraints.

Instead, management waited until the cash was desperately needed. This has created a self fulfilling prophecy of a plunging share price and created significant uncertainty as to whether or not Biolase can raise enough money to satisfy the bank and keep funding operating expenses.

Near term investment thesis

In the near term, solvency concerns and the need to issue stock will entirely control Biolase’s share price. Biolase will be forced to issue up to $20 million of stock. If the stock price can hold up for a few more days then Biolase may be able to issue stock at around $1.40-1.50. But if the stock continues to fall then the offering price could start to approach $1.00. This is an urgent financing for Biolase and therefore the offering should be expected as soon as the S3 becomes effective. This could easily occur within the next few days.

Company background and investment considerations

The corporate predecessor of Biolase was Societe Endo Technic, SA an endodontic and laser product company founded in 1984 in Marseilles, France. In 1994 the company changed its name to Biolase and in 1998 the company adopted the focus it maintains today, developing, manufacturing, and marketing lasers for applications primarily in dentistry as well as dental imaging equipment.

The most important segment of the company’s business is its lasers. Biolase has two categories of lasers, Waterlase, its flagship product, and Diode. Using patented technology, Waterlase combines water and laser energy to perform procedures that would otherwise require dental drills, scalpels, and other traditional cutting instruments. Diode is used to perform less invasive procedures such as pain therapy and teeth whitening. Biolase has 160 issued and 150 pending patents for its laser technologies.

As the company’s flagship product, Waterlase is the most important part of Biolase’s strategy. The key selling points of Waterlase are that compared to traditional methods it reduces pain while improving the safety of dental procedures. Biolase also claims that Waterlase has an advantage because it may be used on both hard (anything involving teeth and/or bone) and soft tissue, something that is not available in other technologies.

Biolase cites the 2007 American Dental Association Survey of Dental Services Rendered ( the “ADA Study”) indicating that more than 200 million hard tissue dental procedures are performed annually in the United States alone. The existing technologies that are currently being used for the vast majority of these procedures are high speed drills for hard tissue (preparing cavities for filling, root canals) and cutting instruments for soft tissue (reshaping gum lines and related procedures).

High speed drills can be problematic because their forces may damage the patient’s dental structure, potentially even causing the patient to need another procedure. Also, drills obviously require anesthesia, and because it is not recommended to anesthetize more than half of the mouth at once, a patient may have to return for multiple procedures if drilling is required in many different parts of the mouth. Finally, the tools used in these procedures can potentially pose risk of infection to patients. According to Biolase, 15 % of dental burs carry “pathogenic microorganisms” which may infect a patient. Cutting tools used on soft tissue don’t appear to be nearly as problematic, but Biolase claims that the discomfort and bleeding are problematic compared to the reduced difficulties that result from use of its lasers. As stated above, Waterlase precisely cut hard and soft tissue with “little or no” damage to surrounding tissue.

While reduced discomfort and tissue damage is obviously a key benefit for patients, the benefits for dentists are at least as important as they are the decision makers.

The company believes that dentists benefit from using its products because of the additional procedures that may be performed using Waterlase that would not be available to dentists with traditional tools. This gives the dentist an opportunity to increase his or her revenue. Biolase also believes that the reduced discomfort provided by its lasers may increase the patient base for dentists who use them, and that the reduced number of post-operative complications that result from reduced surrounding tissue damage will be an important benefit as well.

The company admits that currently only a small percentage of dentists use lasers, and that they are more expensive than traditional tools. Biolase is clearly hoping that its products are in fact superior to the degree it believes, and that as a result its lackluster sales growth thus far will be replaced by more impressive performance. With all this in mind, Biolase is optimistic on the market demand for flagship Waterlase as well as Diode and its other products. However, its important to note that these products have already received FDA approval and have therefore already been exposed significantly to the market, meaning that much of the growth is already factored in with current market acceptance.

Of secondary importance in the company’s product line is dental imaging equipment. Biolase also has three main products in this category, the DaVinci Imaging, Cefla NewTom, and Trios intra-oral CAD/CAM. These systems provide an advantage over traditional technology because they are capable of providing three dimensional images as well as color and higher quality. They also have no time delay. Similarly to the lasers, these provide an advantage to dentists because they may increase the range of possible procedures as images that provide more information due to their more detailed and three dimensional nature may detect problems that would otherwise go undetected for longer periods of time.

Disclosure: I am short BIOL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

STON: A Ponzi dividend set to end


In July 2012, the Whiting USA Trust (WHX) was trading at $18.00 and had just paid one of its highest ever dividends. Whiting had long been subject to heavy criticism due to the unsustainable nature of its dividends which were based on finite oil and gas reserves. Each time a negative article surfaced, the retail investor base shrugged it off or refuted the concerns of the critics. It was notable that institutions and insiders refused to own Whiting. It was almost entirely held by mom and pop retail investors for its dividend yield of at least 10%.

On July 17th, 2012, Seeking Alpha author Shane Blackmon published an article entitled

You’ll Lose 50% Of Your Money If You Hold This Trust For The Next 3 Years

In fact, it did not take 3 years for the stock to fall 50%. By the end of that very day, the shares closed down by 50%.

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The majority of investors had already been made aware that the dividend at Whiting was fundamentally unsustainable in various articles and comments. However, each person was individually certain that they could keep collecting the dividend for the short term, and then exit before the price imploded.

On July 17th, 2012, they found out the hard way that it is impossible to time the implosion of an unsustainable dividend scheme.

Shares of Whiting never recovered, and are now down by more than 70% from their pre-article price. Whiting now trades for below $5.00.

StoneMor Partners (STON) is in a different business than Whiting, but in many respects the problems are identical to those of Whiting.

The stock is often not particularly liquid, however there are very cheap call and put options listed at very frequent strike prices.

Investors should be particularly concerned that institutions and insiders absolutely refuse to own StoneMor, just as they did with Whiting.

Investors should also be concerned about the steady stream of warnings that StoneMor’s dividend is an unsustainable “Ponzi dividend”.

Ultimately we will see that current investors in StoneMor are set to lose around 30-50% relative to the current price. The only catalyst that is necessary is when others decide to sell. This could happen either before the dividend is cut or after.

The reason for this is that the dividend is in no way sustainable. As with Whiting, some investors are already aware of this, but choose to keep collecting the dividend in hopes they can get out before the big drop in the share price.

With Whiting, there was no fundamental change or announcement that led to the 50% drop. Instead it was just that on that day investors chose to stop bearing the risk of the dividend cut and get out. Ultimately the dividend was cut well after the drop in the price of Whiting.

On the surface, StoneMor has all the hallmarks of an ideal retirement portfolio dividend stock. Revenues are stable. The industry is set for continued growth due to the aging of the US population. Gross margins are stable, even though the company does continue to lose money every quarter at the bottom line.

But the biggest attraction of StoneMor is clearly its large and stable dividend of 8-10%. It is the dividend that has made StoneMor a darling among retail investors. Hunger for this dividend has pushed the shares up to over $26, its highest levels since 2011. Many retail investors now seem to regard it as almost a fixed income investment due to these characteristics.

But that is where the good news ends.

The problem with StoneMor is that the “principal” here is far from protected and the yield is far from guaranteed. Despite the low volatility in recent months, regarding this equity as a fixed income security is a dangerous mistake.

Even a cursory analysis reveals significant problems at StoneMor, which indicate that this dividend (and thus the equity price) should be at significant risk. Because the valuation of StoneMor’s equity is entirely dependent upon the dividend, any reduction in that dividend will quickly send the stock down by 30-50%.

We can see that StoneMor has been panned by insiders, institutions, equity analysts and debt analysts. This leaves just passive retail owning more than 90% of the stock.

Now that StoneMor has gone ex-dividend (August 1st), the best move for holders of StoneMor is to take the dividend and run, selling the units.

There has been an abundance of articles which continue to praise StoneMor as an attractive dividend investment. These articles are typically very brief and perform no analysis other than citing the cosmetically attractive dividend along with the attractive fundamentals of the industry. These articles do nothing to assess whether or not StoneMor can actually keep paying this dividend. They also do nothing to explain why this stock continues to have a dividend yield that is several hundred percent above its peers.

This was also the case with Whiting before its collapse. Brief articles noted a high dividend, but failed to test whether or not the dividend could be sustained.

There are numerous red flags which show that the dividend and the unit price are at significant risk with StoneMor. Many of these red flags should be too obvious to ignore.

Each of these red flags is a separate way of noting that the market is telling us it expects a dividend cut. These are the clues from which we can predict the 30-50% downside move.

Red Flag #1: Institutions refuse to own StoneMor

Retail is not the only one who loves dividends. Institutions are big fans of stable dividends as well. Yet total institutional ownership stands at just 9%.

As with Whiting, the institutions are well aware of the unsustainable nature of the dividend at StoneMor. They are also aware that purchasing StoneMor simply for the dividend is a devil’s bargain. As soon as the dividend level is reduced (or as soon as confidence fades in advance), the equity price will fall by far more than the amount of any hoped for dividends.

Red Flag #2: Company insiders refuse to own StoneMor

If the industry is growing and the company is thriving, one would presume that insiders would be eager to lock in an 8-10% dividend as well. Yet the combined total of insider ownership between a dozen different individuals stands at just 3%.

As with institutions, the insiders are well aware that the 8-10% dividend policy is unsustainable. As with Whiting, insider ownership is negligible.

Red Flag #3: Rating agencies have ranked StoneMor as a junk credit

StoneMor equity is not a fixed income security. Neither the dividend payments nor the principal amount invested come with any guarantee. But by looking at the actual debt of StoneMor (which does come with a guaranteed payment of principal and interest), we can see just how risky the equity proposition is.

Despite the stable industry characteristics and the consistent revenues, bothMoodys and S&P rate StoneMor as a junk credit. The current rating of B- is just one notch above being a near uninvestable CCC credit.

S&P had noted an expected recovery value rating of 4, indicating that in an event of default only 30-50% of principal would be recovered.

Both rating agencies express concern that StoneMor is so highly leveraged.

Reasons for rating StoneMor so poorly are explicitly due to the fact that during its entire life StoneMor has never generated enough cash flow to pay its dividend. StoneMor is either borrowing new money or issuing equity to pay these dividends.

The agencies describe this as “negative discretionary cash flow”.

This is the definition of “Ponzi finance”. StoneMor is paying an attractive current return to entice current investors. But the only source of this return comes from the new investment by future investors. Without a constant supply of new investors, StoneMor has no possible way of paying this dividend.

This is a practice which everyone should recognize is dangerous and unsustainable. It always comes to an end. And when it ends, it always ends badly.

S&P previously noted this concern explicitly when putting a junk rating on StoneMor by saying,”Our ratings primarily reflect our opinion that StoneMor’s business model,growth strategies, and ownership structure will result in negative discretionary cash flow that will require ongoing external funding.” S&P added, “In our view, the company’s financial risk profile is ‘highly leveraged’ (as defined in our criteria), primarily reflecting slim operating cash flow.”

But in expressing their opinions, Moody’s and S&P are talking about the risks to debt holders, not to equity holders. The risk to the equity holders is clearly far greater than that of the debt holders, particularly the risk of near term price declines.

Red Flag #4: Clear financial warnings from equity analysts

Surveys such as Valueline and Morningstar continue to highlight warnings on StoneMor.

Valueline continues to rank StoneMor at near its lowest ratings for financial strength, safety and timeliness.

Morningstar continues to rank StoneMor as a “D” for Growth and as an “F” for profitability.

Yet despite these unpromising financial conditions, StoneMor continues to pay out a huge and unsustainable dividend which it finances using new investors.

Red Flag #5: An uninterrupted history of losses

Over the past 5 years, StoneMor has posted roughly 5% annual growth in revenues. But this has largely been the result of increasing acquisitions. These acquisitions and the accompanying revenue growth have not translated into any profitability whatsoever. Over the past 4 years, annual losses have ranged from $6-14 million.

This is clearly why Morningstar ranks StoneMor an “F’ for profitability.

The cumulative loss so far in 2013 is now over $13 million for the first 6 months.

StoneMor bulls attribute these losses to the nuances of death care accounting, by which revenues are not fully recognized until the services are used (ie. the customer is buried).

But we have now had 9 years since the IPO in 2004 for any of this revenue recognition delay to start catching up. Instead, despite new acquisitions (including in 2012 and 2013), the losses have continued.

Pre-tax losses in 2012 did narrow to $4.8 million from $13.7 million in the previous year. However that trend looks to be short lived. The pre-tax loss in 1Q2013 has already come in at over $3 million for the single quarter. One time items in 2Q 2013 resulted in a loss of $11 million for the quarter.

This means that in the first 6 months of 2013, StoneMor has already lost more than it did for full year 2012.

Red Flag #6: StoneMor is close to breaching debt covenants

As of the latest 10Q from just a few days ago, there is a new risk of breeching covenants on StoneMor’s debt.

StoneMor’s debt covenants require that it not exceed a maximum consolidated leverage ratio of 4.0. As of Q2 that level hit 3.97, so it will take almost nothing further to violate this covenant.

StoneMor is also required to maintain a minimum consolidated debt service coverage ratio of 2.50. The current ratio is 3.22, such that if there is just a1% decline in EBITDA, StoneMor will be in violation of its covenants.

Breeching debt covenants will further restrict StoneMor’s ability to pay the dividend.

From latest 10-Q:

We have two primary debt covenants that are dependent upon our financial results, the consolidated leverage ratio and the consolidated debt service coverage ratio. The consolidated leverage ratio relates to the ratio of Consolidated Funded Indebtedness to Consolidated EBITDA. Our consolidated leverage ratio was 3.97 at June 30, 2013 compared to a maximum allowed ratio of 4.00. The consolidated debt service coverage ratio relates to the ratio of Consolidated EBITDA to Consolidated Debt Service. Our consolidated debt service coverage ratio was 3.22 at June 30, 2013 compared to a minimum allowed ratio of 2.50.

Valuation implications

By looking at comparable death care companies, we can see that StoneMor is drastically overvalued relative to any fundamentals. The sole reason for this overvaluation is hunger for the (unsustainable) dividend by retail investors. Were it not for the dividend, StoneMor would quite obviously be trading at roughly half of the current price.

StoneMor has three publicly traded comparable companies, Service Corporation International (SCI), Stewart Enterprises, Inc. (STEI), and Carriage Services, Inc. (CSV). Due to Service Corporation’s pending acquisition of Stewart Enterprises, it’s best to compare StoneMor to only Service Corporation and Carriage Services.

Market Cap. 559.9 Million 4.0 Billion 322.3 Million
P/Sales 2.3 1.63 1.55
TTM P/E N/A 25.8 27.7
EV/EBITDA 25.2 9.3 11.7
Net Debt/Ebitda 7.4 2.8 5.3
Credit rating B- BB BB
Dividend Yield 9.2% 1.5% 0.7%

Profitability: StoneMor is the only one of these peers that loses money, the other two are actually profitable companies.

Debt (leverage): StoneMor is also far more leveraged than its peers, with a very high Debt/Ebitda ratio of 7.4. This is the leverage concern that was expressed by the rating agencies.

Credit rating: StoneMor is rated 4 notches below its peers by the rating agencies – just one notch above a CCC credit. It two comparables are both rated BB, just 2 notches below investment grade.

Valuation: Despite these drawbacks, StoneMor trades at a substantial pricepremium to its peers. StoneMor’s Price/Sales ratio is roughly 50% higherthan its peers. EV/Ebitda is more than double its peers.

It is quite obvious that the only reason for this drastic valuation discrepancy is the massive difference in dividend yields. While the comps pay out 0.7-1.5% annual dividend yields, StoneMor pays a stunning yield of over 9%.

This is also how we can come to the conclusion that any meaningful cut in the dividend is likely to see the price of StoneMor fall by at least 30-50%.

A closer look at the unsustainable dividend

As shown in the charts below, StoneMor’s dividend has been climbing steadily, even though it has not generated enough cash to pay these dividends in any of the past 4 years. In any given year the shortfall ranges from $14-40 million.

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So far in 2013, StoneMor has again paid out nearly $25 million in dividends, despite bringing in only $16 million in OCF.

As a result, in each year, StoneMor has tapped the debt and equity markets. In effect, this means that StoneMor is simply raising money from new investors in order to pay off the existing investors. 

So far in 2013, StoneMor has again already raised around $20 million from new investors, net of its debt repurchase. It has also made use of its credit facility with its banks.

The problem is that the base of investors who need to receive a return keeps growing larger and larger.

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Meanwhile, we can see that despite stable revenues, StoneMor continues to be unprofitable every quarter.

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Distributions approaching a breaking point

Schemes such as this are always unsustainable. When they suddenly end, it comes without warning.

As the investor base continues to grow, the financing need grows exponentially larger as does the need for finding an ever growing supply of new investors.

StoneMor has been tapping both equity and debt investors in order to continue funding this above market 8-10% dividend.

Part of the problem lies in the fact that insiders and institutions refuse to own StoneMor. In most cases, retail investors either cannot or will not perform the analysis necessary to properly evaluate the security. Instead they just keep cashing their dividend checks and hoping for the best.

In its recent earnings announcement, StoneMor illustrates why retail investors have been overly confident in receiving their dividend even as institutions steer clear.

The earnings release states that

Distributable free cash flow (non-GAAP) for the three-month period ended June 30, 2013 increased to $24.9 million from $13.3 million for the same period last year, an 86.8 % increase.

Hopefully more astute investors will realize that the term “distributable free cash flow” is a fabricated non GAAP measure and specifically does not refer to operating cash flow. It is effectively a made up metric.

For example, the release noted that “distributable free cash flow” in 2Q2012 had been $13.3 million. In reality, OCF that quarter was only $6 million. Against that $6 million in OCF, StoneMor had paid out $12 million in dividends that quarter. As usual, it financed this by issuing debt.

Had StoneMor actually generated that $13.3 million in cash, there would be little to be concerned about when paying a $12 million dividend for the quarter. But instead, we can see clearly that this metric is meaningless as StoneMor still needed to http://www.varley.net/online/ borrow to pay the dividend for which it lacked cash. In reality, StoneMor paid out a dividend which was double what it actually generated in OCF.

It is important to note that this arbitrary non-GAAP “distributable free cash flow” number does not even approximate real cash flow. According to the company, the components of this number include GAAP cash flow, plusadditions for the Merchandise Trust. But as disclosed in the most recent 10Q:

The merchandise trusts are variable interest entities (VIE) for which the Company is the primary beneficiary. The assets held in the merchandise trusts are required to be used to purchase the merchandise to which they relate. If the value of these assets falls below the cost of purchasing such merchandise, the Company may be required to fund this shortfall.

Adding in the value of the Merchandise Trust into this new “distributable free cash flow” metric renders it basically meaningless.

It is notable that StoneMor’s treatment of this “distributable free cash flow” has already been evaluated by the SEC and this view has been rejected. Yet StoneMor continues to disclose this manufactured and arbitrary metric as a way of suggesting that the dividend is in some way sustainable.

The $24.9 million in “distributable free cash flow” for 2Q2013 is a very inspiring number on the surface. But it is misleading in two respects. First, it includes a one time cash benefit of a lawsuit win by StoneMor.

But more importantly, it uses the same flawed methodology to suggest that StoneMor is actually generating cash that it is not.

In reality, StoneMor paid out the largest dividend in its history at nearly $13 million during Q2. Meanwhile, actual operating cash flow stood at just $9 million. So once again, StoneMor paid out around 150% of its OCF as a dividend.

But the impression given by the recent press release is that StoneMor only paid out $13 million while generating $24.9 million. This is simply not the case.

Meanwhile, the share count has now ballooned to over 21 million, up by more than 50% in 4 years. Total debt now stands at $230 million. Interest paid during the first 10 months is already at $10 million.

As the investor base has expanded, each of the new investors becomes “entitled” to the ever expanding payment obligations.


StoneMor continues to be unprofitable and generate insufficient cash flow to pay its dividend. StoneMor continues to tap the debt and equity markets for ever larger sums in order to continue paying an above market dividend. As a result, its share count and debt obligations have continued to expand over the years.

StoneMor’s continued publication of the “distributable free cash flow” has confused some retail investors into believing that the company does have adequate cash flow to pay its huge 9% dividend. However the SEC has already disallowed that methodology for computing cash flow.

Paying out an enormous 9% dividend has now become quite obviously unsustainable. As the investor base continues to expand, the payment obligations expand exponentially creating the need to continually raise ever larger amounts of new money from more and more investors. StoneMor has now disclosed that it is now dangerously close to breaching debt covenants (within 1%).

As with the Whiting Trust, StoneMor is likely to fall by 30-50% as soon as investors decide to exit.

As with Whiting, the catalyst for this move is not dependent upon StoneMor cutting the dividend in advance.

Now that the stock has gone ex-dividend and earnings have been announced, there is simply no reason to continue holding the stock. The best move is to exit and eliminate the 30-50% downside risk before other sellers act first.

Disclosure: I am short STON. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Implications of Organovo Lawsuit


I last wrote about Organovo Holdings (ONVO) on July 24th.  Since my last article, there have been several new developments which further reinforce the short thesis on the stock. The stock has continued to fall as expected.

First, the S3 registration statement for up to $100 million of new shares and/or warrants has now become effective. Some acheter cialis 20mg individuals had previously taken comfort that no offering would be impending because the S3 was not yet effective. It is now the case that Organovo is free to issue up to $100 million of equity securities at any time.

Second, I have uncovered an undisclosed legal action against Organovo by their own investment banker, Spencer Trask Ventures (“STV”). The initial arbitration filing  was submitted on June 27th, when STV demanded compensation which is now valued at around $28 million. Under the terms of the original Placement Agency Agreement, Organovo had agreed to binding arbitration. However, on June 28th, Organovo  filed in New York Civil Supreme Court to attempt to fight the arbitration.

There have now been a flurry of arguments and counterarguments in New York Civil Supreme Court during the monthsof June and July.

One issue is that this may prove to be a significant financialissue for Organovo. But as a totally separate issue, this isalready a significant disclosure problem for Organovo.

None of this has been disclosed to investors, including in theS3 registration statement which just became effective a fewdays ago.

Preliminary points

Before getting into these issues, there are a few preliminarypoints that deserve to be made.

Following my article, Seeking Alpha contributor Jason Napodanowrote a forceful rebuttal to my article. It was his 4th bullisharticle on Organovo in less than 1 year.

In his article, Mr. Napodano makes it clear that the points inmy article are either entirely irrelevant or else downrightinaccurate. The author supports these statements with a mix offacts, opinions and anonymous postings from a Yahoomessage board.

There are now three main issues which investors need toresolve for themselves.

  1. How much (if any) of the 32 million share overhang iscurrently depressing the share price ?
  2. How much (if any) equity is Organovo likely to issue underthe recent S3 registration statement ?
  3. How much (if any) revenue is Organovo likely to generatein the next 1, 5 and 10 years ?

Clearly I disagree with Mr. Napodano on each of these points.

A substantial overhang pressing on the share price from the 32million shares from 2012 is evidenced by the fact thatOrganovo still filed a subsequent prospectus on these shares.Once the overhang is fully removed, there will not be additionalprospectuses.

Organovo is likely to complete a very large financing under the$100 million S3 sooner rather than later. It has been less thanone year since the company deliberately reduced the exerciseprice of the existing $1.00 warrants to just 80 cents in order toget money in the door at that price. We can also see from theSTV lawsuit that Organovo tried to incentivize STV to exerciseby reducing the strike price to just 60 cents. This means thatOrganovo was attempting to issue new shares at a price of just60 cents as recently as February / March.

For revenue, Organovo may have some prospects with liver cellmodules at sometime in 2014. But we have been given noindication of the certainty or the amounts which may beinvolved. The key point here is that the hype surroundingOrganovo is in connection with the 3D printing of humanorgans. Not even the most bullish authors expect to seemanufactured human organ revenues any time in theforeseeable future. Instead, we will continue to see smallamounts of revenue from grants and research collaborations.Historically these have typically been in the range of six figureamounts.

In the meantime, we can see that Organovo has beensuccessful in two areas:

- selling stock to investors at $1.00 (or below)

- elevating its share price to above $6.00

The company has recently been sporting a fully diluted marketcap of nearly half a billion dollars, despite the followingfinancial metrics:

- lifetime revenues of just a few million dollars (coming fromgrants and research)

- non cash assets (including all intellectual property) of lessthan $2 million

Metrics like these do not justify a market cap anywhere nearhalf a billion dollars.

A very small but vocal minority of readers continues to posttheir emotional comments below these articles. However amuch larger (and silent) majority chooses to express theirviews by selling their stock rather than typing up rabidcomments.

Prior to my article, the stock was hitting $7.70 in pre markettrading. Following my article the stock fell to $6.50.

It is now the case that all investors have the benefit of fullinformation from these various articles and comments and theshare price continues to slide rather than recover any lostground. Following his article on Organovo, Mr. Napodano left asubsequent comment stating that he believes that ”fair value”for the stock is around $4.00-5.00 - an additional decline of asmuch as 20% from the current level. In the near term, I wouldagree with this statement, which is why I continue to be shortthe stock. Although any potential equity offering couldpotentially push the share price even lower.

An undisclosed legal action

In its past financings, Organovo used the services of SpencerTrask Ventures for raising what now totals roughly $28 millionin proceeds from stock and warrants. As of March, Organovohad $15 million in cash remaining.

The lead individual involved was Adam K Stern, a ManagingDirector with STV. Mr. Stern also became a Director ofOrganovo.

According to the terms of the Private Placement Agreement,Organovo would pay to STV a cash fee equal to 10% of theproceeds along with ”agent warrants” ($1.00 strike price, 5 yearmaturity) equal to 20% of the stock issuable to investors.There was also an 18 month ”tail” provision allowing foradditional fees to be payable to STV based on subsequentcapital raises. A key point of contention in the current lawsuit isthat it was agreed that STV would be appointed as an exclusiveWarrant Solicitation Agent at least 20 days prior to any noticeof redemption. Organovo agreed to not contact any of theinvestors introduced on STV’s proprietary investor list.

In 2012, Organovo Director Stern left Spencer Trask and wentto Aegis Capital. Shortly thereafter, the arbitration suit statesthat Organovo began the warrant solicitation to raise newmoney from STV customers. But instead of using (or evennotifying) STV, Organovo used Mr. Stern’s new firm, Aegis.

In total, Organovo raised $14.8 million through the warrantexercises. In fact, Organovo lowered the exercise price onwarrants to just 80 cents in order to raise new money at thatlevel.

STV did not find out about any of this until it became publicinformation through Organovo filings.

STV and Organovo are now in a protracted legal battle in whichSTV is demanding the disgorgement (and payment) of $14.8million along with $1.3 million in cash fees and the issuance of2.9 million warrants owed. The warrants alone would currentlybe worth around $12 million. Total consideration is thereforenow in the area of $28 million.

During 2013, and after the warrant transactions conducted viaAegis, Organovo and STV began negotiating a Warrant Agreement which would arrange for payment of compensationto STV. A second draft of the Warrant Agreement was alsoprovided.

On March 1st, Spencer Trask’s attorneys sent an email toOrganovo CEO Keith Murphy rescinding the proposedagreement. A copy of the rescind email can be found here.

Following the rescinding, Organovo still sent small payments toSTV, however these payments totaled just $115,000, instead ofthe much larger sum demanded by STV.

Section 13 of the Placement Agency Agreement states (in ALLCAPS) that any ”dispute, claim or controversy” which arises withrespect to this agreement will be submitted to JudicialArbitration and Mediation Services Inc. (“JAMS”) in the State ofNew York.

STV filed for arbitration on June 27th.

The next day, on June 28th, Organovo filed to fight the movefor arbitration, stating that the Warrant Solicitation Agreementvoided both the compensation earned by STV as well as theneed for arbitration.

As is often the case, many dirty secrets get spilled out inlawsuits. Organovo reveals that it had already agreed to pay toSTV $23 million in exchange for helping Organovo raise just$15 million in proceeds. The need to pay such a fee isstaggering in and of itself.

The lawsuits also reveal that Organovo was willing to lower thestrike price on STV’s warrants to just 60 cents, in order to raiseequity at that level. This was not in the distant past. This was inFebruary / March.

Both of these facts speak loudly to the fact that Organovo hasalways been eager to issue equity at just about any price, nomatter how low. The company has virtually no non-cash assetsand continues to generate only minimal and non-commercialrevenues. So getting money at any price may well be the beststrategy.

But it also reconfirms my suspicion that if the company is eagerto issue substantial equity for just pennies, then it will likely bea very large issuer of equity with the price sitting at just over$5.00. A normal discount for an equity offering like this wouldbe around 20%, meaning that an offering would likely takeplace at around $4.00. The stock price would then reactaccordingly.

Investors now need to ask themselves two very importantquestions:

First, how much of the $28 million in demanded compensationwill Organovo end up paying to Spencer Trask ?

Second, why are investors hearing about a potential $28million legal liability from me, rather than from Organovo in an8K or S3 legal disclosure ?

Reverse mergers in perspective

Commercializing a new product or service in the real world is anarduous and time consuming task. Successes are rare andoften take decades to make themselves evident.

Reverse merger stock promotions, in sharp contrast, are fareasier. It is very simple