Short $SSTI: ShotSpotter is worse than you thought

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Summary:

  • In over 20 years SSTI has never generated profits or meaningful cash. Recent IPO simply allows VCs to finally exit positions. Dec 4th lockup expiration on 8 million shares
  • Reams of independent data and test use confirm that SSTI ‘s technology simply doesn’t work. Period. Customers repeatedly describe overwhelming failure rate.
  • Aggressive tactics by SSTI thwart release of FOIA docs to journalists and researchers. Employee testimony states SSTI provides fabricated data to law enforcement.
  • Multiple recent undisclosed contract losses (just ahead of lockup expiration) and inflated 3Q revenue.
  • Contracts such as Miami and Baltimore (and others) have been repeatedly announced, then quietly cancelled, re-announced, but then quietly cancelled again.

Note: This article is the opinion of the author.  The author is short SSTI.

I suspect that much of the information in this article may actually come as a surprise even to certain board members.  ShotSpotter has historically provided very optimistic reports to its board members, touting the unmitigated success and “proof” of its products, without including information like I have included below.  A copy of one of these reports is included below.


***   SHOTSPOTTER INC. (SSTI) – KEY STATS / COMPANY DESCRIPTION

Ticker SSTI LTM Rev $21.8m
FD Shares O/S 11.69m LTM Net Loss -($8.3m)
Mcap ≈$200m Cash per share $1.65
Share price ≈$16
52w Lo/Hi $9.33 / $20.15 Price/Sales 9.1 x

Note: Share count of 11.69 million shares includes 2.05 million shares underlying deep in the money warrants and options with an average strike price of $4.55.  Sell side analysts continue to ignore these 2.05 million shares.

ShotSpotter Inc. (SSTI) offers software and hardware systems which provide locational information on gunshot activity within covered areas. When someone fires a gun, ShotSpotter’s microphones detect the gunshot and send the data to a ShotSpotter center in California.  It is then determined if it is indeed a gunshot. Finally, the location of the gunshot is relayed to law enforcement personnel.

 


***   SHOT SPOTTER INVESTMENT THESIS – SUMMARY

Below I will make clear the following points to show why ShotSpotter will quickly fall by around 80% to $2-4, once the lockup expires on December 4th.

  1. Uninterrupted history of failure. After a 23 year history of uninterrupted commercial and financial failure, ShotSpotter was suddenly publicly hyped in 2017 as an innovative high tech solution to gun violence, so that it could come public in an IPO by Roth Capital. For two decades ShotSpotter has had repeated brushes with outright insolvency.
  2. The IPO was arranged as the only exit for insiders from a business that has been unable to succeed for more than 20 years. The purpose of this IPO was simply to allow insiders and PE investors to exit an otherwise unsellable, money losing investment. On December 4th, 8 million shares will be released from lockup, allowing these investors to finally sell.  Ahead of that lockup expiration, ShotSpotter juiced its revenues by pulling forward nearly$1 million of revenues from a cancelled Puerto Rico contract and then failing to disclose other contract cancellations.
  3. ShotSpotter. Does. Not. Work. Period.  Reams of hard data prove quite conclusively that ShotSpotter simply does not work.   This is why ShotSpotter has repeatedly been unable to maintain customers or generate any profits despite 20 years of trying. Actual documented success rates of less than 2%, with 70-80% of all alerts being unfounded or false alarms.
  4. Customers explicitly state that ShotSpotter does not work and fully confirm the hard data. New customers keep canceling. Following their cancellations, former customers confirm categorically that ShotSpotter simply does not work.  Including major “trophy” contracts such as Baltimore, Miami, San Antonio and Oakland.
  5. ShotSpotter employee testimony (under oath) states that data presented to law enforcement is outright fabricated.
  6. Aggressive tactics to conceal, distort or prevent outright the release of the “damning” data. Internal memos reveal aggressive tactics by ShotSpotter to thwart FOIA requests by journalists and universities seeking transparency into government spending on ShotSpotter. Deliberate steps to legally gag police forces from disclosing the negative data.  The data being withheld is the same data that categorically proves that ShotSpotter simply does not work.
  7. ShotSpotter fails to disclose major contract losses ahead of lockup expiration.  In its November earnings call, ShotSpotter indicated clearly that only one contract had been lost.  Below I show the proof that 3 more contracts have been lost but not disclosed by ShotSpotter ahead of the lockup expiration.
  8. ShotSpotter makes diametrically opposing statements to law enforcement, journalists and university researchers, depending on its financial interest in each situation. ShotSpotter presents one set of facts to law enforcement when selling its product to government payers. It then presents the opposite “facts” to parties trying to investigate spending on ShotSpotter and its effectiveness.  ShotSpotter also presents additional “facts” which contradict its own data when marketing the product. The government payers who buy ShotSpotter are relying on the wrong data.

 


***   SECTION 1 – OVER 20 YEARS OF UNINTERRUPTED FAILURE AND LOSSES

ShotSpotter’s technology is not new.  Neither is gun violence.

ShotSpotter’s founder, Robert Showen came up with this idea all the way back in 1994 when he kept hearing the sounds of gunfire in neighboring East Palo Alto. Over the years, there have been a few minor improvements to the technology to try to weed out more false positives (from other loud noises). But overall, the technology is still largely the same as it was 23 years ago.

Recent media headlines have been dominated by gun violence. But in fact, the US has had an epidemic problem of gun violence for decades.  Despite this decades of ongoing violence, ShotSpotter has not been able to achieve any real traction, and certainly no profits for more than 20 years.

Here is a list of gun violence incidents that made major US headlines, all in 2015 or earlier.  The point is that high profile gun violence has been a problem in the US for decades, yet it has not allowed ShotSpotter to ever generate a profit.

Date Incident Date Incident
12/2/2015 San Bernardino Attack – 14 killed 11/5/2009 2009 Fort Hood Shooting – 13 killed
10/1/2015 Umpqua Community College Shooting – 9 killed 4/3/2009 Binghamton Shootings – 13 killed
6/17/2015 Charleston Church Shooting – 9 killed 4/16/2007 Virginia Tech Massacre – 32 killed
9/16/2013 Washington Navy Yard Shooting – 12 killed 4/20/1999 Columbine High School Massacre – 13 killed
12/14/2012 Sandy Hook Elementary School Shooting – 27 killed 10/16/1991 Luby’s Shooting – 23 killed
7/20/2012 Aurora Movie Theater Shooting – 12 killed 8/20/1986 Edmond Post Office Shooting – 14 killed
1/8/2011 2011 Tucson Shooting – 6 killed 7/18/1984 San Ysidro McDonald’s Massacre – 21 killed

ShotSpotter has repeatedly been forced to raise new money via private placements in order stave off insolvency, with investors describing the company as “ subsisting on fumes”.  At one point, ShotSpotter decided to change the direction of its business and attempt to create a“big data” play on its detection of gun shots. At the time, “big data” was the hot new thing.

That “big data” plan fizzled entirely.  But the collection and analysis of the “big data” did have one result:  there was now enough data gathered to prove categorically that ShotSpotter’s technology simply does not work.

This was obviously very, very bad. So ShotSpotter quickly adopted a campaign to thwart any release of that data, including blocking access for universities seeking to research it under the Freedom of Information Act.

These points are fully substantiated below. Evidence is provided via internal memos, court documents, investigative journalists and complaints by former customers.


***   SECTION 2 – THE IPO (AND UPCOMING LOCKUP EXPIRATION) AS AN EXIT FOR TRAPPED INVESTORS

After more than 20 years of providing cash infusions to keep afloat this struggling business, these private investors were finally unwilling to put in any further funds.

In March of 2017, ShotSpotter was once again down to just $2 million in cash but had debt and current liabilities of $25 million.  By this time, ShotSpotter had never turned a profit and had an accumulated deficit of $89 million. As usual, ShotSpotter was again “running on fumes”.

With private equity no longer willing to fund it, in June of 2017, ShotSpotter decided to come public in an IPO led by Roth Capital.

Not surprisingly, the bankers behind the IPO are also the exact same banks who are pumping out bullish research on ShotSpotter. Roth Capital, Imperial Capital and Northland Capital.

When the lockup expires on December 4th, these are the same banks who will make millions of dollars in banking fees by running the secondary offering for the insiders to sell over 8 million shares.

Not surprisingly, each of these banks has been able to ignore the wealth of information that I present in this article.  A large December fee event will no doubt provide a nice bump up in each of their year end bonuses. The support of these analysts therefore comes as no surprise.

Here is what we are hearing from Roth Capital, Imperial Capital and Northland Capital just ahead of this pending lockup expiration. So far they have made no mention of the concerns I raise below.

Imperial Capital sees +30% upside for Shotspotter

Northland Capital Markets Starts ShotSpotter (SSTI) at Outperform

ShotSpotter initiated with a Buy at Roth Capital

PT Raised to $19.75 at Imperial Capital on 3Q Report

Roth Capital Raises ShotSpotter Inc. (SSTI) Price Target to $23.00

ShotSpotter Inc. (SSTI) Given a $20.00 Price Target by Imperial Capital Analysts


***   SECTION 3 – SHOTSPOTTER. DOES. NOT. WORK. PERIOD.  (THE DATA)

The data against shot spotter is absolutely and overwhelmingly conclusive. And it comes in great detail from a wide variety of completely independent sources. Each of these point to the same exact results.

As I will show in a subsequent section, ShotSpotter has undertaken significant efforts to thwart the release of any performance data for its product.  This is because the data is absolutely horrific. It proves conclusively that the product provides no material benefit whatsoever.

But an investigative journalist from Forbes was able to separately obtain and analyze much of the data behind ShotSpotter.  His conclusions were beyond compelling.

The data obtained by Forbes in 2016 showed that ShotSpotter provided huge numbers of alerts to law enforcement, but that more than 98% of these alerts ended in no arrests being made.

Up to 70% of the alerts were described as entirely “unfounded”.

Roughly 90% of the time, no police report was ever even filed following the alert from ShotSpotter.

ArticleShotSpotter Alerts Police To Lots Of Gunfire, But Produces Few Tangible Results

 

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City Total alerts Un-founded % of Total Reports taken % of Total Arrests Total
Brockton 296 152 51.4% 43 14.5% 2 0.68%
East Palo Alto 1,725 1,089 63.1% 237 13.7% 4 0.23%
Kansas City 6,619 2,513 38.0% 714 10.8% 108 1.63%
Milwaukee 10,285 7,201 70.0% 172 1.67%
Omaha 1,181 737 62.4% 92 7.8% 14 1.19%
San Francisco 4,385 1,412 32.2% 76 1.7% 2 0.05%
Wilmington 1,278 399 31.2% 256 20.0% 5 0.39%

And then this gets interesting.

In trying to attract and retain customers, ShotSpotter repeatedly touts the high number of alerts that its system puts out, indicating that the higher the number of alerts, the greater the benefit it is providing

But as we will see below, the high alert rate itself is actually the biggest problem, because the overwhelming majority of ShotSpotter alerts are nothing more than false alarms.

The data above is the quantitative proof which ShotSpotter has been aggressively trying to suppress from public view. It is notable that the data are highly consistent across cities of all sizes and locations within the country.

In fact, additional qualitative proof comes in the form of public statements from municipal officials and law enforcement who went on the record to publicly explain why they were abandoning this system after spending huge sums of tax payer money to have it installed.


***   SECTION 4. – “DAMNING” COMPLAINTS CONFIRMING THAT SHOTSPOTTER SIMPLY “DOESN’T WORK”.

Below I present the on-the-record comments made by law enforcement officials and government officials who have actually used and evaluated the ShotSpotter system.

What you should notice is this:

The comments below precisely echo the quantitative data above, even though they come from a wide range of totally different cities.

In addition, (just like the city data above), the verbal comments and complaints below are highly consistent among one another.

Once again, each of these cities says the exact same thing: that ShotSpotter simply doesn’t work.

The list of cities who have cancelled ShotSpotter and then publicly decried its total lack of effectiveness specifically includes cities such as Miami, Baltimore, San Antonio and Oakland. These cities have been repeatedly touted as being on the cusp of providing major revenues to ShotSpotter.  But then the contracts with those cities have been cancelled or discontinued prematurely with little or no revenue at all.

#1 – Miami previously cancelled and said ShotSpotter doesn’t work

Recent headlines have indicated that ShotSpotter is on track to implement a major contract installation in Miami.  ShotSpotter is a brand new IPO, so perhaps investors can be forgiven for not knowing the prior history of major contract announcements (specifically for Miami) which were then repeatedly cancelled with little or no revenue.

Local Miami media is already skeptical of the latest supposed Miami contract, because they have seen this gambit with ShotSpotter before.

ArticleShould Miami-Dade Police Spend $5 Million on a Gunshot Detector They Abandoned Before?

Both the Miami Police Department and the Broward County Sheriffs Department have publicly gone on the record to state that ShotSpotter simply does not work. Worse than that, implementing the system results in a massive diversion of police resources to unfounded calls, taking officers away from actual crimes being committed.

This is why both the city and the county cancelled their previous contract.  (Below we will see in greater detail the mechanics behind the repeated re-announcements of contracts that are then cancelled with little to no revenue).

In Miami, for every one verifiable gunshot, there were at least twenty false alarms.  After more than a year, the system led to just four arrests.

ArticleMiami Politicians Push ShotSpotter Even Though Some Local Cops Say It Doesn’t Work

 

02 - new times miami

 

 

 

Actually this was the second time that ShotSpotter had been tried and then quickly rejected in Miami (Broward Sherriff’s Office).

Here was the first time they ditched ShotSpotter:

Article: BSO Pulling Plug On Gun Shot Spotter

According to the sheriff’s office:

They could chalk up only four arrests to the system compared to the many man hours wasted by deputies checking out false alarms.” Apparently, ShotSpotter could not distinguish between “gunshots, firecrackers, vehicle backfires or big trucks downshifting on nearby I-95.

#2 – Baltimore cancelled and said ShotSpotter doesn’t work

Just like Miami, we have seen multiple public announcements trumpeting a ShotSpotter contract for Baltimore.  These reports were actually entirely wrong, but few people ever saw the quiet corrections down the road.

As with Miami, despite some flashy news in 2017, Baltimore had already tried, evaluated and then cancelled ShotSpotter on two separate prior occasions.

In February of 2014, SSTI posted to its web site a very prominent post highlighting that the Baltimore police department would be implementing ShotSpotter. This announcement was exceptionally high profile because by this time the gun violence crisis in Baltimore had already surpassed Chicago in severity.

ShotSpotter websiteBaltimore Police to Invest in Gunshot Detection System

03 - balt yes

 

 

 

It took until a full year later, but we finally found out that this post was not only grossly premature, but it also turned out to be completely wrong.In fact, a full year later we found that this contract never went in to place at all in 2014 and that it would not be doing so going forward. In other words, in 2014 this information was so preliminary that it should have never been posted by the company at all. And in the end it turned out to be just flat out wrong. The contract had never even happened in the first place a full year earlier.

 

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ArticleBaltimore won’t buy gunshot detection system

05 - balt no 2 small

 

 

We can see from Baltimore the consistent complaint from law enforcement. Not only does ShotSpotter not work, but implementing it actually causes even larger problems. As shown above, Baltimore stated that:

the fight against crime would be adversely affected by proceeding with the system.

In 2017, Fake News announces a Fake Contract for Baltimore. SSTI shares spike higher.

 

And yet despite this obvious past conclusion, investors quickly fell for the same old gag when it was announced (yet again) in 2017 that Baltimore would once again adopt the system.

 

ArticleAs murder rate soars, Baltimore Mayor Pugh seeks help from Gov. Hogan

 

06 - balt yes 2017

The share price of ShotSpotter immediately spiked by 10%. Few investors noticed when that “news” was quietly retracted a few days later in a tiny note at the bottom of that same article.

 

RetractionBaltimore police will expand gunshot detection, get more laptops for police cars – Technical.ly Baltimore

07 - balt no 2017

 

 

 

#3 – Charlotte cancelled and said ShotSpotter doesn’t work

In 2016, Charlotte refused to renew its contract with ShotSpotter, after having used the system for four years. More important were the comments that Charlotte police made at the time, noting that:

the gunshot detection system didn’t help them makes arrests or identify crime victims.

 

ArticleCharlotte ends contract with ShotSpotter gunshot detection system

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From the above:  

Police were only able to find evidence of a gun being fired in one out of 41 reports.

 

#4 – Oakland cancelled its expansion and has said ShotSpotter doesn’t work

The city of Oakland has been described as the “third most dangerous city in America”.

But in a review of ShotSpotter, Oakland police were quoted as calling the “ technology as not only ineffective, but also counterproductive.”

 

ArticleOakland cops aim to scrap gunfire-detecting ShotSpotter

 

Oakland police have also called the system:

expensive and redundant…They say residents already call to alert police when they hear gunfire, and the money could be better used to fund other technology, such as the police helicopter.

Keep in mind, that Oakland is right in the backyard of ShotSpotter and its founders.

As of recent quarters, Oakland was still a partial customer of ShotSpotter.

On the recent conference call on November 7th, ShotSpotter indicated clearly that aside from Puerto Rico/Virgin Islands, there had been no other contract losses.

But as far back as April 28, 2017 the city of Oakland had already publicly disclosed that it was discontinuing its expansion of ShotSpotter.  Phase I had already been implemented, but Phases 2 and 3 have now been cancelled. As is always the case, the part actually implemented was small, while the majority of the previously announced contracts were actually cancelled without providing the “expected” revenue to ShotSpotter.

In fact, given the public statements to the press by Oakland police, these cancellations really should have come as no surprise whatsoever.

 

10 - oakland budget

Link: Oakland Budget – Apr 2017

Clearly someone in the Oakland municipal government has a favorable opinion of ShotSpotter.  But in fact, the police have actually been trying to scrap the program for years – since 2014In its attempts to keep Oakland from cancelling their entire program, ShotSpotter then slashed its fees dramatically.

11 - oakland cancel 2014

ArticleLink

 

#5 – San Antonio cuts ShotSpotter and said it doesn’t work

As shown below, although ShotSpotter has publicly indicated that it hasn’t lost any major contracts other than Puerto Rico/Virgin Islands, the company’s San Antonio contract has already been lost in recent months.

In October 2016, SSTI announced that ShotSpotter was expanding into eight new areas, San Antonio being one of them.

12 - san antone 8 new cities

 

 

 

 

ShotSpotter IRNew York City, Chicago, Birmingham and Miami-Dade Among Eight Areas Expanding Gunfire Detection System

Just 10 months later, however, San Antonio cut funding for ShotSpotter citing the high cost against the fact that there were only 4 arrests made.

 

13 - san antone cuts funding Link: S.A. cuts funding to $550K gunshot detection program that resulted in 4 arrests

According to the assistant to the SAPD Police Chief:

about 80 percent of the times when ShotSpotter was activated, police could find no evidence of a shooting at the scene…

The San Antonio Police made it very clear why they were cutting ShotSpotter.The system simply didn’t’ work.

Over the course of 15 months, the system only resulted in a mere 4 arrests – at a cost over $136,500 per arrest !

In their own words, San Antonio Police summarized the system well:

  • “It doesn’t make the community feel safer”
  • “It doesn’t reduce the number of gunshots in our community”
  • “It doesn’t prevent you from being shot.”

In other words, the only party to benefit from the massive tax dollars spent on ShotSpotter is….well….ShotSpotter itself.

Article: San Antonio police cut pricey gunshot detection system

14 - san antone long w quotes

 

 

 

 

 

#6 – Fall River cancelled and said ShotSpotter doesn’t work

Fall River is another interesting example.

The question is this:  Did ShotSpotter lose the Fall River contract or not ?

On the one hand…it is true that Fall River continues to use the ShotSpotter product.

But on the other hand…after Fall River recently canceled their contract, ShotSpotter just now started providing Fall River with the service for FREE.

Clearly the contract that ShotSpotter had signed with Fall River required payment for the service and clearly those payments are no longer being made.  In other words, “Yes”, the contract has been cancelled.  But “No” the loss of this contract has not been announced by ShotSpotter. In fact, the data provided by ShotSpotter on November 7 th clearly indicated that aside from Puerto Rico/Virgin Islands, no other contracts had been lost.

For now, ShotSpotter has offered to continue to provide free service to Fall River such that it feels that it does not need to disclose the contract loss until after the lockup. Very convenient !

But here’s the rub:  once the lockup expires on December 4 th SSTI will have no more reason to lose money by proving free service to non paying customers. I expect that at that time the cancellation of the contract will finally be announced.

15 - fall river ditch

 

 

 

Article:‘False alarms’ lead Fall River to ditch ShotSpotter system

Along with a 41 percent false alarm rate and an expensive price tag, Fall River police have reported that there have even instances where ShotSpotter failed to report gunshots in locations where the sensors were located.

 

16 - fall river free

ArticleFall River to keep ShotSpotter program for free

 

#7 – Troy,MI cancelled and said ShotSpotter doesn’t work

Yet another former customer who discontinued its contract with ShotSpotter is the city of Troy, who discontinued its contract in 2012.

16 -troy turn off

ArticleTroy will turn off ShotSpotter

According to the Troy police department, “The system was suppose to become attuned to the way sounds were heard in Troy’s streets and differentiate among the brakes of a truck climbing the Hoosic Street hill, from a firecracker, actual shots and any other noise.” These attributes were “never completely achieved.”

 


***   SECTION 5 – SHOTSPOTTER EMPLOYEE TESTIMONY STATES  DATA PROVIDED TO LAW ENFORCEMENT IS OUTRIGHT  FABRICATED

SSTI employee Paul Greene is a “Manager of Forensic Services at SST Inc.,” according to his LinkedIn page.

 

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Testifying under oath in the Reed trial, which was brought about after a man (“Reed”) shot at a car full of people in 2016, Paul Greene was questioned about the accuracy of the ShotSpotter system.

19 -paul g text 1

 

 

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In addition, in a prior deposition, Greene revealed that ShotSpotter has faced at least five separate court challenges to the validity of the science behind it.

Why was Paul questioned in the first place ? The ShotSpotter system alerted police to a location that was a full city block away from the actual shooting.

Article: Courtroom testimony reveals accuracy of SF gunshot sensors a ‘marketing’ ploy

Some members of law enforcement are already catching on to ShotSpotter’s “marketing” ruses.

Last year, Memphis police deputy chief Jim Harvey posted on his LinkedIn page a request for feedback on ShotSpotter. Instead, he was inundated with feedback from various people with various direct and indirect ties to ShotSpotter itself

According to Forbes, here is what happened:

21 -memphis sherriff article

ArticleShotSpotter struggles to prove impact as silicon valley answer to gun violence 

 


***   SECTION 6 – INTERNAL MEMOS:  MANAGEMENT AGGRESSIVELY CONCEALING AND OBSCURING THE OVERWHELMING EVIDENCE

In order to attract new customers, ShotSpotter has implemented an aggressive campaign to suppress and conceal all of the negative information about the product.

At the same time, ShotSpotter aggressively supplies these officials with a deeply misleading sub-section of statistics to allow them to tout how it is in fact tremendously effective!

The Freedom of Information Act (“FOIA”) was passed in 1967 to provide transparency into the workings and decisions of government so as to avoid fraud and waste.

From the website FOIA.gov

22 -what is foia

 

Internal memos from ShotSpotter reveal the aggressive tactics that ShotSpotter is using to thwart the release of data under FOIA

FOIA allows for several exceptions including for law enforcement, public safety, and trade secrets.  In fact, the only “secret” that ShotSpotter is trying to protect is the fact that its product simply doesn’t work and that it is a waste of federal and local tax dollars.

In internal memos, ShotSpotter is not shy about saying that the purpose of withholding this information is to protect its own business from “harm” that would be caused by releasing the data.

ShotSpotter instructs recipients to:

#1 – simply refuse to release, or

#2 – release data that is heavily redacted to not show the terminal flaws shown above

#3 – “ Obscure” the most important information

And then even when any information is actually released, ShotSpotter has specifically instructed its recipients to deliberately provide only paper copies of the heavily redacted information so as to further thwart dissemination online by anyone.

The screenshot below is a “ Customer Success Training Bulletin” circulated by ShotSpotter.

23 -sst internal memo

Notably, ShotSpotter is more than happy to release data which simply shows the huge number of raw alerts.  This information is then used for marketing purposes.

The grand irony here is that it is precisely this excessive number of false alerts that is precisely the reason why ShotSpotter is so ineffective and wasteful of public resources. But because ShotSpotter deliberately stymies the release of the full data set, this large number of alerts actually looks like a net positive for the system. As a result, no one is the wiser.

Below I show repeated examples where ShotSpotter actively promotes itself based on the notion that “a high number of alerts equals a higher level of public safety”.

Some of the data below has been released directly from ShotSpotter’s web site. Other material has then been re-disseminated through third party sites which quote the original data being put out by ShotSpotter.

Selling the board of directors:

These are the exact type of stats that ShotSpotter management feeds to its board members in periodic “progress reports”. The reports contain very brief “news” articles which read more like press releases and contain heavy amounts of data supplied directly by ShotSpotter itself. They also contain lengthy “ case studies” which were written by management to tout success stories.  But in reading the “case studies” more closely, it becomes interesting to observe the large number of “satisfied customers” who then canceled their contracts subsequent to the date of the report.

 

Screen Shot 2017-11-21 at 5.52.12 AM

Link: Full document

The point is this: ShotSpotter actively promotes its product on the basis that “more alerts equates to greater public safety”.  In fact, as we can see from the data and the customer complaints, the exact opposite is true.  The biggest problem is that ShotSpotter results in false alerts as much as 70-90% of the time.  But because ShotSpotter has largely concealed the data, the public and the government payers may not know until after they use and then cancel the system.


***   SECTION 7 – SSTI FAILS TO DISCLOSE MAJOR CONTRACT LOSSES AHEAD OF LOCKUP EXPIRATION

News of each of these contract cancellations occurred in time to be included in ShotSpotter’s November 2017 earnings release.

Despite this, ShotSpotter has not disclosed any of these cancellations.

In some cases, in response to cancellation, ShotSpotter has taken to “giving the service for free” to delay reporting the cancellation until after the lockup expires. But the fact is that such customers already announced their cancellation and are no longer paying ShotSpotter.

Also, keep in mind that these are just the ones I have already found.  There may be additional undisclosed contract losses that I have not yet found. But I will continue looking, of course.

On the earnings call on November 7th, the comments made by CEO Ralph Clark made it very clear that aside from Puerto Rico/Virgin Islands, the company had not lost any other contracts.

Puerto Rico was important because it was ShotSpotter’s 2 nd largest customer accounting for 10% of revenues.  It was a big loss, but at least it was (according to the CEO) the only loss.

We can see this from the Q2 transcript.

CEO Clark stated that net new miles gone live in the quarter was only 17.  The total gross new miles was 50. But Clark stated clearly that the number of square miles lost in Puerto Rico/Virgin Islands was exactly 33.

In other words, ahead of this key lockup, Mr. Clark has made it very clear that aside from Puerto Rico/Virgin Islands, ShotSpotter has not lost any other customers.  This information has clearly provided strong support to the stock price just ahead of the lockup expiration where insiders can finally sell their shares.

Cancellation #1 – San Antonio. Newspaper articles from as far back as August 2017 were already noting that San Antonio was cancelling its contract. They were quite clear in stating their reasons why:

Specific quotes from San Antonio Police include:

  • about 80 percent of the times when ShotSpotter was activated, police could find no evidence of a shooting at the scene
  • the system only resulted in a mere 4 arrests – at a cost over $136,500 per arrest
  • “It doesn’t make the community feel safer”
  • “It doesn’t reduce the number of gunshots in our community”
  • “It doesn’t prevent you from being shot.”

Article: San Antonio police cut pricey gunshot detection system (Aug 2017)

Even though this cancellation (and the reasons why) could be found as early as 6 months ago, ShotSpotter has recently continued to insist that the only lost contract was Puerto Rico.

Cancellation #2 – Fall River. As we also saw above, Fall River, MA is no longer paying for the service, but ShotSpotter is continuing to provide the service for free so as to not disclose the loss of the contract ahead of the lockup expiration.

ArticleFall River to keep ShotSpotter program for free (September 2017)

ShotSpotter has agreed to let the city of Fall River continue to use the system for free, Mayor Jasiel Correia announced Thursday.

 

Cancellation #3 –  Oakland, CA

As far back as April 28, 2017 the city of Oakland had already publicly disclosed that it was discontinuing its expansion of ShotSpotter.  Phase I had already been implemented, but Phases 2 and 3 have now been cancelled. As is always the case, the part actually implemented was small, while the majority of the previously announced contracts were actually cancelled without providing the “expected” revenue to ShotSpotter.

In fact, given the public statements to the press by Oakland police, these cancellations really should have come as no surprise whatsoever.

24 -oakland budget 2

 

 

 

***   SECTION 8 – SHOTSPOTTER MAKES CONTRADICTING STATEMENTS TO LAW ENFORCEMENT VS. JOURNALISTS AND UNIVERSITY RESEARCHERS

In fact, beyond this deliberate distortion of the data above, ShotSpotter goes much further in disseminating information that is flat out incorrect.

We can see repeated examples where ShotSpotter gives one set of facts to law enforcement customers but then gives contradicting “facts” to researchers and journalists who are investigating the use of ShotSpotter.

Here are 3 examples:

Example #1 – “Alternative facts” on crime data

Jennifer Doleac is an assistant professor of public policy and economics at the University of Virginia who attempted to get her hands on the data underlying ShotSpotter to assess whether it actually works and if it is a sensible use of tax dollars.

ShotSpotter adamantly rebuffed any and all efforts to obtain the data for analysis. When Ms. Doleac requested the information citing that the data was a matter of public interest – crime data – Mr. Clark sent her a strongly worded letter insisting that ShotSpotter was now a “Cloud based services model” and specifically that SST’s ShotSpotter data is NOT crime data”.

Obviously this statement from Clark defies common sense. We know that any data related to urban gunfire is going to be crime data.

This statement by ShotSpotter CEO was a convenient excuse for the company to suddenly refuse to release the data which would prove that the product is a waste of taxpayer dollars.

As shown in the examples below, ShotSpotter has consistently described its data as crime data when that served a useful marketing purpose.  But when the release of “crime data” became a threat to ShotSpotter became a threat, the CEO simply changed his story.

From ShotSpotter’s website:

Law enforcement is no longer dependent on 911 calls with ShotSpotter because it instantly notifies officers of gunshot crimes in progress with real-time data.

25 -gun crime data 1

From ShotSpotter’s brochure: “ Key Benefits: … Proactive gun crime pattern analysis & strategic deterrence.”

25 -gun crime data 2

The point is this:  In trying to sell its product to government payers, ShotSpotter repeatedly highlights the value of its crime data. But as soon as it fears it will have to turn the data over to independent investigators in FOIA requests, ShotSpotter simply claims that this data is no longer “crime data”.  ShotSpotter will say anything (even contradicting its own earlier statements) to prevent the release of the reams of data which prove that the product does not work.

Example #2 – Because ShotSpotter doesn’t work, the company invents new metrics in order to sell the product to new cities.

ShotSpotter clearly doesn’t work in even remotely the way it is marketed.  We can see that from the raw data as well as the detailed comments from law enforcement across the country.  We can also see it in various court documents and investigative articles.

We know from the data and complaints above that ShotSpotter doesn’t improve public safety or reduce gun violence.  In the vast majority of cases, the system can’t even determine if any shot was fired at all.

So instead, ShotSpotter has taken to inventing new “success objectives” for the use of its product.

Even if there are no arrests or other public safety benefits, ShotSpotter tries to convince the public that there is some benefit to things like:

finding shell casings well after the fact“sending a powerful message to law abiding citizens”“ better community relations”“ enhanced situational awareness

 

ShotSpotter IR: Dozens of Shell Casings Found in Two Separate Shootings

Clark] said he wondered if the department was defining success in the wrong way.

ShotSpotter allows police to make a quick response to gunfire…which sends a powerful message to law-abiding citizens and shooters that police take gunfire seriously.

There’s a few things that are problematic,’ said Monroe County Assistant Public Defender Katie Higgins…‘[ ShotSpotter] was not designed to be used as actual primary evidence (in a trial),’ she said.

 

ShotSpotter IR: ShotSpotter alert leads police to shell casings near vacant Peoria house

 

According to Forbes, ShotSpotter claims that there is a longer term benefit which (of course) is much harder to verify or quantify.  As an example, SSTI frequent cites the fact that even when there are no arrests, apprehensions or even suspects, there is often crucial evidence that is gathered which can result in convictions even years down the road.

Forbes describes the value of this supposed benefit as “overstated”, which I believe is a considerable understatement.

For example, a ShotSpotter audio recording was used in the prosecution of a shooting that occurred in Mahoning County, Ohio. However, the expert witness provided by ShotSpotter could not provide details on key findings that would have corroborated other testimony.

According to the Assistant county prosecutor, “We still would have been able to secure conviction [without ShotSpotter].”

Effectively, ShotSpotter is just coming up with creative excuses for why law enforcement should continued spending tax payer money on a system that has been thoroughly and repeatedly debunked.

Example #3 – Vocally pretending that ShotSpotter causes visible drops in gun violence

Regardless of whatever any data says and regardless of the complaints from past disgruntled customers, if ShotSpotter could actually be seen to deliver a visible drop in gun violence then it would certainly be able to win over more potential new customers.

It is therefore not surprising that ShotSpotter is out there making aggressive “ cause-effect” claims about how SS directly reduces the incidence of violence.

Each of the following links come from ShotSpotter’s investor relations department. They show that ShotSpotter is marketing itself on the basis that “using ShotSpotter leads to lower gun violence”.

ShotSpotter claim: Springfield, Mass. topped the nation with the largest reduction in New Year’s Eve celebratory gunfire, down 60 percent from 2013 to 2014, according to ShotSpotter data

ShotSpotter claim:’We are extremely pleased with the dramatic decline in gunshots Fall River has seen over the last few years…While the 57.4% decrease in shootings is substantial, there is still much more to do…”

ShotSpotter claim:“ Among U.S. cities using SST’s ShotSpotter technology, three of the top five with largest reduction in gunfire incidents from 2014 to 2015 were: New Haven, Conn. (-38.5 percent, Atlantic City, NJ (-35.4 percent), and San Francisco, CA (-34.6 percent).”

ShotSpotter claim:“ Other top cities using ShotSpotter and with significant reductions in celebratory gunfire on New Year’s Eve include: Stockton, Calif., with 38.2 percent decline (from 136 to 84 incidents); Miami Gardens, Fla., with 37.5 percent decline (from 48 to 30 incidents); and Rocky Mount, NC, with a 19.3 percent decline (from 57 to 46 incidents).”

ShotSpotter claim:“ In addition to Fall River’s gunfire incidents declining 57.4 percent, the following cities experienced impressive reductions and are willing to share their successful approaches for gun violence reductions: Springfield, MA – 51.2%, Camden, NJ – 48.0%, Plainfield, NJ – 39.8%, East Palo Alto, CA – 29.1%, Oakland, CA – 26.1%.”]

Here is the truth:

Despite the alarming headlines over high profile mass shootings in places like Vegas and Texas, gun violence has actually been on a steady and consistent decline across the entire US.

The tables below show that gun violence has been steadily deceasing across the US for the past 10 years. This includes for the country as a whole as well as for wide range of individual cities which have never used ShotSpotter at all.  Yet ShotSpotter continues to claim the its system is responsible for these declines.

Quite obviously this assessment stands in stark contrast to the data presented above  and the detailed experiences of law enforcement.

 

26 -gun violence natl decline

 

Link: Pew Research – Gun Violence

26 -gun violence natl decline 2

 

Article: The Economist

As can be seen clearly in the table above, cities across America have seen a very steady decline in gun violence, whether or not they had any use of ShotSpotter at any time ever.

The implementation of ShotSpotter technology is not what is “causing” the reduction in gun violence any more than SS is “causing” the sun to shine in those cities.  But ShotSpotter is more than happy to claim credit for “causing” this reduction which is in reality just part of a decade long macro trend.

ShotSpotter’s claims that it somehow results in a reduction in gun violence are entirely bogus and unsubstantiated.

Disclosure: This article is the opinion of the author.The author is short SSTI.  The author may trade one or more securities mentioned within the next 72 hours.

 

Long $RH – $RH Will Spike Much, Much Higher Very, Very Soon

Summary

  • In May, RH quietly awarded its CEO a massive nine figure incentive package to achieve a $150 share price by any means. Two days later RH announced a $700m buyback.
  • In 2017, RH already bought back half of all outstanding shares at prices below $50. Stock then doubled. Further financial engineering can easily attain $150 quickly.
  • In October, tiny debt repayment sent stock up 20 points. Now $650m of converts nearing conversion price. But RH previously bought “bond hedges” which neutralize any convert dilution.
  • Despite much higher share price, short interest now falling as some shorts realize the financial engineering trap. But short interest still near 50% of float.
  • RH suddenly announced its first “investor day” after more than two years. Past events saw announcements move the stock big. Only eight trading days away.

 

Note:  This article is the opinion of the author.  The author is long RH and HTZ.

Key statistics

Name:                         RH (formerly “Restoration Hardware”)

Ticker:                        (RH)

Market cap:                $1.8 billion

Current price:             $89.24

52w Lo/Hi:                 $24.41  / $91.81

Shares out:                21.2 million (float of 18.6 million)

Shares short:             8.8 million (48% of float,  9 days trading volume)

Avg. Volume:             1.1 million shares

 

 

***   Section 1: Summary investment thesis

Shares of RH are being driven sharply higher as a result of financial engineering being conducted by RH’s CEO Gary Friedman.  Throughout this article, please understand that the described reductions in share count have nothing to do with any type of meaningless “reverse split”. Instead, with RH these are actual and permanent reductions in share count which are having a very predictable effect on the price of each remaining individual share.

Right now some shorts appear to be taking the view that “if RH was a good short at $30, then it must be an even better short at $90”.  But in fact, the share count has been reduced so aggressively (via share buy backs) that the market cap of RH is only up by 30-40% since April.  Moreover, this moderate rise in valuation is arguably not far out of line with the recent improvements in financial results (and outlook) as announced in September.  The September announcement alone saw the share price spike 45% in single day. The shares repurchased by RH were bought at far lower levels and much of these purchases were conducted with cash (not just debt), such that even the comparable rise in enterprise value is also far much lower that this sharp rise in the share price.  In other words, comparing the price of a single share between one period and the next is no longer a consistent picture of the valuation of RH as a whole.

So here is what is happening:

In May of 2017, RH’s CEO Gary Friedman was quietly awarded a staggering nine figure incentive package if he can somehow engineer the share price to $150 or higher.  Precisely how he achieves this goal is entirely irrelevant.

If Friedman is successful, the value of the total awards to him will exceed $500 million.  At least $25 million of this will come to him within just the next few months. All that is necessary for Friedman to receive this payout is the financial engineering and ongoing reduction of share count coupled with even just very slight improvements in RHs business (in fact, whether real or perceived).

Mr. Friedman did not waste any time in putting his plan into action.

Within just two days of that award (on May 4th, 2017) RH quickly announced a $700 million share buyback to sharply reduce the share float.  Some were surprised at the buyback because RH’s stock price had already been rising towards the highest prices of the year (then closing in on $50).

Even more surprising (to some) was that within just 50 trading days, RH had announced that it had already completed the entire $700 million share repurchase, accounting for a significant portion of the daily volume during that time.

What I will describe below is how Friedman is now using a combination of positive cash flow and new debt to further reduce the share count. Friedman is effectively conducting a “stealth/quasi/creeping” going private in order to drastically reduce share count.  Ultimately, for Friedman to take home his nine figure package, the equity float must go lower. And this is what is happening.  The impact on the share price is entirely predictable.

Throughout 2017, RH has already repurchased half of its outstanding float at an average price of $49.45. The share price has already nearly doubled since those purchases.

But what about the all of that debt ?

Because of its increased leverage, the market has been very focused on RHs “capital structure”.  But changes in leverage can now cut both ways. As a result, when RH suddenly announced three weeks ago that it was already paying down its $100 million second lien term loan (within just 3 months of it being issued), the stock quickly shot up 20 points from the $70s to the $90s, quickly hitting new 52 week highs.  And yet clearly that was a just relatively small deleveraging.

Of RHs remaining debt, the majority ($650 million) is in the form of convertible debt with strike prices of $116 and $118. And now suddenly these conversion prices are quite squarely within range.

But….did you also know that in 2014 and 2015, RH had already purchased complete “bond hedges” from underwriter BofA-ML to fully neutralize dilutiononce those convertibles convert at prices over $116 and $118.  There is therefore no dilution until the share price exceeds well over $170.

In 2014 and 2015, RH paid BofA-ML over $130 million for the long legs of these bond hedges to neutralize dilution.

(Terms, details and dilution tables for the bond hedges are included below).

Yet the market has missed the details of these convertibles and bond hedges because just a few months ago, the share price was still below $50, making conversion seem highly unlikely.

(And quite frankly, I am very skeptical that many investors ever even knew about these massive bond hedges in the first place.)

Even aside from earnings announcements, Friedman has made use of other ongoing announcements to propel the share price higher over the past 5 months.  There was the announcement of the share repurchase, the announcement of Friedman’s own open market purchases of $2 million in RH stock in the $70s and then the announcement of the early repayment of RH’s second lien notes in October.  Each time, these separate announcements have driven the share price sharply higher.  This is how we have gotten from the $40s to the $90s in just 8 weeks.

The next catalyst for a sharp spike higher

And now in just 8 trading days from today, RH has suddenly decided to conduct its first “investor day” after more than two years.  In the past, RH has made very visible use of such events to make announcements which then sent the stock sharply higher.

There are a variety of announcements that Friedman could be expected to make at (or in advance of) this “investor day”.

The most obvious announcement would be that RH would announce the simple approval of the next leg of its ongoing share buyback.

Or RH could announce a subsequent reduction of leverage.

Or Mr. Friedman could simply reiterate his recent very bullish views on RH’s near term prospects, both in the US and in Europe.

Given the 48% short interest in RH and the moderate trading volume, any of these announcements could easily fuel an immediate and very sharp spike in the share price.

In the event that RH announces yet another shift in the capital structure (i.e. the next leg of the stock buyback or the next debt pay down), such a spike would most likely be permanent rather than temporary.

In the near term, if the share price stays above $100 (up just 11% from current levels) in the next few months, Mr. Friedman will receive an extra $4 million under the recently awarded incentive package.

But if the share price goes North of $150 then just that first near term incentive award swells to $25 million to be doled out to Mr. Friedman in just the next few months.

So ask yourself this:  in its first investor day in more than two years, and with $25 million looming in near term incentives, do you think Mr. Friedman will say something positive or something negative  

Link:  RH to Host Investor Day on November 16, 2017

***   Section 2: Financial engineering works again and again.

Back in August, I published my long thesis on Hertz Inc. (HTZ) when the stock was at just under $14.  Many people thought (and said) that I must have lost my mind.  The share price (they said) was clearly wildly higher than what Hertz’s troubled fundamentals could justify.  And Hertz’s “capital structure” (they said) would only serve to turbo charge a decline in the share price.  Just before I published my article, a SELL recommendation from Barclay’s raised the specter of bankruptcy, sending Hertz’s stock plunging by 40% in 2 days.

Hertz shares plunge 21 percent after Barclays downgrade

Against that, all it took was for the slightest of ongoing results to be “less awful than expected” and Hertz was set to skyrocket.  And this is exactly what happened.  With short interest at greater than 50% of the float, a modest rise in the share price turned into a sharp spike and Hertz’s share price jumped 40% within days. The share price then quickly went on to double to around $28.  Hertz is now up by around 75% since where I wrote about it. I am currently long a moderate amount of Hertz.

As I was with Hertz, I am totally aware of the short thesis on RH.  In fact, just as with Hertz, I even agree with many of the FUNDAMENTAL observations of the short thesis on RH.

But I will show what the market has missed and why shares of RH are set to very quickly spike sharply higher from here (and then stay much higher going forward).    And just as with Hertz, it is the “capital structure” (and changes to the capital structure) which will now turbo charge the share price much HIGHER rather than lower.

Important:  Once we saw what Carl Icahn was doing with Herbalife (HLF), it then became very easy to see what Icahn was doing with Hertz.  It became very obvious that the price for any single share for each of those companies would have to rise, even despite very visible challenges with their underlying fundamentals. Changes in the share price between one period and the next were no longer comparable for valuing the company as a whole.  

With HLF, I tend to agree strongly with Ackman (bearish) about the business, but even more strongly with Icahn (bullish) on the expected direction of the share price.

01 - HLF

 

 

 

 

 

 

 

 

 

 

02 - HTZ

We can now see similar tactics being used by RH CEO Gary Friedman to “engineer” the RH share price to much higher levels. It has worked with HLF. It worked with HTZ and now it will quickly work with RH.

 

***   Section 3:  Looking at the RH short thesis

By now, the short thesis on RH is quite well known and has been widely disseminated for over two years in a variety of media outlets including Grants, The Wall Street Journal and Baron’s.

In fact, on a strictly fundamental basis, I actually agree with many of these obvious concerns raised by the financial media.  But it just doesn’t matter. The share price is headed sharply higher.  These media outlets had all raised similar concerns about names like Hertz and Herbalife as well, even as those stocks went on to soar dramatically in price.  Notice the prices of RH at the time of these articles (as well as their titles).

Date Source RH

Price

Title
 
Aug 2017 WSJ $53 Restoration Hardware’s Wild Ride to Nowhere
March 2017 WSJ $33 RH’s Hard to Believe Restoration
Dec 2016 Barrons $34 Restoration Hardware: Fears Turn to Reality
Jun 2016 Barrons $31 Restoration Hardware Tough to Handle
 

So here is the (widely known) RH short thesis in a nutshell:

RH sells very high end (i.e. “over-priced”) furniture to a small demographic of upper income customers. The overall size of that demographic is already quite small and their continued purchasing power is heavily dependent upon ongoing appreciation in real estate and stock market assets.   Revenues at RH have steadily increased, and have been driven by a significant expansion effort into a) more stores and b) larger and larger store formats.  Once the economy slows (and with it the real estate and stock market values), purchases from these customers will slow sharply.  That store expansion (which has so far helped RH) will then become a weight on the business.    Many shorts also assume that any decline in RH will then be turbo charged by recent changes in its “capital structure”.  This is because RH has been aggressively been buying back its own shares and financing those purchases by issuing debt.  Leverage has therefore increased sharply.

But against this short thesis, there is a very visible wild card which has been a significant head scratcher for anyone who has been short the stock.

RH CEO Gary Friedman has also been using his personal funds to aggressively acquire millions of dollars worth of RH shares in the open market. His earlier purchase of nearly $1 million in July of 2016 could arguably be justified by the low price of $27.50 at the time.

But then in September of 2017 (just 6 weeks ago) Friedman again used his personal funds to purchase an additional $2 million of stock at an average price of $70.28. Friedman’s latest purchases occurred at the highest share prices for RH since late 2015. Friedman’s most recent purchases at $70.28 in September marked the beginning of the subsequent rise in the stock from the $70s to the $90s, a further 30% rise in just those 6 weeks.

 

03 - Friedman buys

 

 

 

04- RH price

So let’s look at what the larger market is missing here.

***  Section 4:  Smarter shorts have been very QUIETLY reversing their views on RH

(Hint: No short seller is going to tell you that they are desperately looking to get out of their position in RH.  Duh.  Given the information below, I would be rightfully be quite skeptical if anyone who was short RH started aggressively trying to convince me to sell my shares of RH.)

A few months back, short interest in RH had exceeded 60% of float.  This is what we call a “suicide short”.    With the stock having doubled since this time, it has certainly lived up to the name “suicide short”.

Since that time, the short interest has fallen to 48% of float. It is still basically a “suicide short”, but clearly some of the smarter shorts have started to comprehend the implications of the ongoing financial engineering by RH’s CEO, which will continue to send the share price ever higher.

And note that even this small level of short covering over the past two months has contributed to the sharp rise in RH’s share price.  From September through October, short interest fell only modestly from 58% of float to 48% of float but the share price rose by more than 20 points during that time (and this continued rise was already AFTER earnings had been released).   So if there is a larger unwinding of short positions, then we should expect a much larger upward move in the stock from here.

05 - short int graph

Also remember that on September 7th RH shot up by 45% in just a single day, from $49 to $71, following the release of better than expected earnings and guidance. So that is the level of short term price volatility we have come to expect from RH when it puts forth a meaningful new announcement.

 

06 - HCP

 

 

 

 

 

 

 

 

 

 

 

 

 

 

At nearly 50% of float, the remaining short interest is still absolutely massive. Even attempting to slowly get out of small positions is noticeably pushing up the price of RH.  The current short position amounts to fully nine days of trading volume.

This is why existing shorts are trying to be very QUIET about getting out of their positions in order to minimize a potentially significant short squeeze from here.

But as we have often seen in the past, there will inevitably be some “dumb money” that gets badly burned.

The dumb money is staying short on the simple view that  “if RH was a good short at $30, then it must be a great short at $90”.

***   Section 5: The Bull Thesis for RH (on the share price, not the business)

Share price vs. valuation

Yes, during 2017 shares have more than tripled off of their sub $30 lows. And yes, anyone who has been long or short during this time has participated 1:1 in this 60 point move.

But it is very important to understand that this categorically DOES NOT mean that the VALUATION of RH has tripled.   In other words, despite the share price move, RH has not necessarily become equally expensive as a company.

The all time high for RH was just over $100 in 2015. So as we now approach that level again, some people are tempted to try to call the top in the stock.

But because of the changes to the capital structure since 2015, the market cap of RH is less than half of what it was back then, while the enterprise value (“EV”) is actually half a billion dollars LOWER – EVEN at the same share price of around $100.

Conclusion: Because of continuing changes in the capital structure, comparing the share price from period to period is no longer an accurate reflection of changes in the value of RH as a company.  

Just during 2017, RH has been making use of very aggressive share repurchases to cause a PERMANENT reduction in the outstanding share count.  As a result, despite the “triple” in the share price, the market cap has only risen by less than 50% since the end of Q1.

In addition, aside from the debt funding much of the share repurchase were conducted with cash and the average purchase price was at just $49.45.  As a result, the rise in EV has also been far less than what would be surmised by looking at the share price.

Think of it this way:  RH borrowed around $600 million to buy back $1 billion of stock at the time.  The balance was paid for with cash. The value of that debt stayed constant at around $600 but the value of those shares repurchased has since nearly doubled to nearly $2 billion.

And remember that the 50% rise in market cap that we have seen this year was actually coming off of a very low base.  The share price had been sitting at deep multi year lows.

In addition, some amount of bounce from those levels is arguably quite justifiable given that in September:

  • GAAP revenues increased by 13% (relative to single digit growth at competitors).
  • Earnings came in at 65 cents per share vs. 44 cents in the year prior (an increase of 48%)
  • RH boosted guidance on 2017 revenues to $2.42-2.46 billion
  • RH boosted 2017 net income guidance to $70-77 million

Analysts have also upped their outlook for RH substantially.  Consensus wall street expectations for earnings this year has increased by 43% over the last 6 months to $2.60 currently from a low of $1.82. 

The recently improved outlook is actually quite significant.

In fact, we can see that RH currently trades at around 26 times consensus earnings estimates. This is actually slightly LOWER than where RH has traded vs. estimates in the past.  It is also steeply lower than the 30-40x multiple where RH traded two years ago (when the stock was also near $100).  So the stock price comparison of today is truly no longer comparable.  It is apples to oranges.

RH share price multiple vs. consensus earnings estimates__ historical mult

 

 

My only point is that some level of valuation increase is certainly merited vs. 6-9 months ago.  And once we factor in changes to the capital structure, the moderate rise in RH’s overall valuation is not excessive.

SO HERE IS THE BIG QUESTION:

Question…  So are these share repurchases just “financial engineering” to artificially make the price of each share higher ?

Answer…   YES, YES, YES. These repurchases are absolutely financial engineering.

But…. It simply doesn’t matter. The share price will continue to go much higher as the actual share count continues to decrease. In addition, even very small improvements in earnings (or even just in guidance, Mr. Friedman ! ) will start to have a disproportionately larger impact on the price per individual share.

Anyone who has been long or short the stock during 2017 has participated 1:1 in the share price rise.  And they will continue to participate 1:1 as the share price moves up towards its next level of $150. Because that is the level to which CEO Gary Friedman needs to “engineer” the stock price.

***   Section 6:  In 2017, Friedman was given a NINE FIGURE incentive to engineer a $150 share price for RH

On exactly May 2nd of 2017, RH quietly awarded CEO Gary Friedman a massive nine figure contingent equity compensation package which aggressively incentivizes him to increase RH’s share price.  The precise method of HOW he achieves this price is entirely irrelevant.

The incentives to Friedman have an “exercise price” of $50 per share but are “restricted” until the share price reaches prices of $100, $125 and $150.  If he does not meet these share price targets, then the options are restricted for a period of 20 years. Mr. Friedman is currently 60 years old.

From the Form 8K dated May 2, 2017.

08 - Friedman award 8k

As noted, the options contain time restrictions and are awarded over a four year period. But under certain conditions, the options all get awarded immediately AND they then vest immediately too.  We will see this below.

On the date of that award in May 2017, RH closed at $48.62 such that the large award size seemed not-so-relevant vs. their restriction prices of $100-150.  (Obviously they are suddenly looking much more relevant now that RH has doubled in just 6 months.)

And here is where it gets interesting.

On May 4th 2017 (just two days after Friedman received his incentive) RH suddenly announced that that it had authorized a $700 million share repurchase program.

09 - May 4th $700m

 

 

With his massive incentive package in place, Friedman didn’t waste any time in aggressively reducing the outstanding share count.  Within just 50 trading days (on July 14th) RH announced that it had already completed the entire $700 million repurchase. Wow, that was fast.

09a - $700m complete

 

In fact, this $700 million buyback followed on the heels of a $300 million buyback in Q1 (just a few weeks earlier) which had been effected in the run up to Friedman’s incentive package being awarded to him.

Together this means that in just a six month period, RH bought back 20.22 million shares, cutting the outstanding share count by half (49.6%) from where it stood in early 2017.  Against the total outlay of $1 billion, we can see that RH bought those shares for $49.45 (and they are now trading at around $90).

So yes, the share price has tripled since Q1 from below $30 to over $90.  But because the share count has been cut in half, the market cap has only increased by 50% from those deep multi year lows.

And again, since that time we have seen sharp improvements in revenues, earnings and cash flow, such that a higher valuation is certainly justifiable.

As a result, against all expectations, the first of Friedman’s trigger levels (the $100 mark) is suddenly squarely in sight.  As we will see below, from here it will be very easy to for Friedman to get the price per share to $150 using the exact same technique.  And the massive short interest is only going to help Friedman make this happen even sooner.

From the RH Proxy Statement (dated later in May 2017) we can see the breakdown of how these options are awarded.

 

 

The takeaway from the table above is that if Friedman can keep the stock above $100 (just 11% above current levels) by the 1st anniversary of his award (i.e. in May 2018) he will be awarded an extra 83,333 shares which would be worth an additional $4.2 million. (Remember, the strike price is $50 such that the intrinsic value of the awards would be $100 minus $50=$50.)

11 - 83,333But….

If Friedman can get the stock a bit higher, to above $150, by May 2018 then two things will happen.

First, the intrinsic value goes up by 100% (not by a mere 33.3%).  At a share price of $150, intrinsic value goes from $50 to $100 per option (i.e. $150 stock price minus $50 strike price = $100 intrinsic value).

More importantly, under the schedule above, Friedman would also get three times as many underlying shares.

In other words, if CEO Gary Friedman can get the share price over $150 by May 2018, just his FIRST brand new additional award will suddenly be worth a cool $25 million just a few months from now.  It’s a pretty nice incentive package.

So ask yourself this:  what do you think Mr. Friedman has in mind to announce at his first “investor day” after more than two years ?!  We will find out in just 8 trading days.

Identical awards are to be given to Friedman over each of the four upcoming years, such that in addition to his paid salary and bonus, and in addition to the shares that he already owns, this single incremental incentive piece then pays Friedman an additional $100 million over four years

Looking back to that $2 million purchase of RH stock that Friedman made in September.  Friedman bought those shares at $71. So if the stock price does rise to $150, he would make a profit just over $4 million.  But his incentive awards would end up being worth over $100 million.

It is very clear to me that these ongoing purchase of stock by Friedman have more to do with “signaling” so as to help him get the stock price to $150. They have less to do with the actual economics of those newly purchased shares.  Signaling or not, these purchases will most likely have the desired effect and will continue to boost the share price higher.

As a result, I fully expect to see Mr. Friedman continue to make more open market purchases even at prices well over $100.  It only makes sense.  And when the CEO starts announcing his open market purchases at all time high prices of over $100 per share, I fully expect that this will have the exact effect that Mr. Friedman desires (in other words, more buys by Friedman will again drive the even stock higher).

Either way, after 40 years in the retail business and at the age of 60, Mr. Friedman is getting within pistol shot of locking in a near term nine figure payout.

 

***   Section 7:  OK…but what about all of that debt ?

One thing keeping many shorts in place on RH is the fact that these massive share repurchases have been largely financed with debt.  Because of the share repurchases in 2017, RH’s total debt load went from $532 million in July of 2016 to $1.15 billion by the end of the July 2017 quarter (announced in September 2017).

So basically an extra $600 million in debt to take out $1 billion in stock.

(The $1.15 billion debt figure is the number disclosed in July by RH.  RH also has $233 million in “capital leases” associated with its properties which some analysts treat as debt).

Beyond that debt, the balance of the funds used to buy back stock were obtained from operating cash flow as well as from cash on hand.  The cash on hand was largely the result of previous bond offerings.

We can see quite clearly that RH’s share price is indeed very, very sensitive to any changes in its capital structure.  But this knife cuts both ways.  Any REDUCTION in leverage can also send the share price spiking sharply higher.

On October 10th RH announced the early repayment of its $100 million 9.5% second lien term loan.  At the time, RH was still trading at just $72.  In the three weeks that followed, RH then quickly soared by more than 20 points as investors started to recalibrate their assessment of RH’s “Capital Structure”.

Much of that $100 million repayment was actually more of a refi, with RH using a 2.75% asset backed facility to make the payment.  Even though only a portion of that term loan was actually repaid with cash, the share price still spiked sharply higher.

12 - repay $100m

 

My point is that when we (very soon) see even larger reductions in leverage, we should expect to see much greater upward spikes in the share price. 

In fact, that tiny refi / pay down was very small potatoes compared to what is coming next.

Just a few months ago, when RH’s share price was below $50, no one seemed to focus on the fact that $650 million of RH’s debt is actually convertible into stock.

The conversion feature may have seemed largely irrelevant at the time because the conversion prices on those convertible bonds are set at $116.09 and $118.13 which was more than 100% above the prevailing share price just few months ago.  It seemed safe to assume that if there was to be any eventual conversion than it would be far into the future.

But as recently as September (after the share price had spiked above $70), RH was already telegraphing it investors how it viewed this “debt”.

For some reason, RH began “carving out” the calculating of those convertibles. In the September earnings release, RH suddenly described its total indebtedness as follows. (Note the carve out of the converts, as well as the advance disclosureof the bridge loan repayment which then happened 4 weeks later).

Outside of the convertible notes that are due in June 2019 and June 2020, we had aggregate debt of approximately $504 million at the end of the second quarter, including a $100 million second lien bridge loan that we expect to repay in full by year end.

Here are the terms of those two convertibles.

Convertible terms:  $116.09 strike zero coupon convertibles

Convertible terms:  $118.13 strike zero coupon convertibles

But now with the stock closing in on $100, those conversion prices become much more relevant because that “debt” can be extinguished if the share price stays above the $116-118 levels.  It is now becoming clear why RH was alerting us to this back in September.

And then it gets even better. The “bond hedges”.

Even fewer people are aware that back in 2014 and 2015 when RH issued those convertibles, the company simultaneously entered into “call spread” transactions (AKA “bond hedges”) with BofA-ML (the convert underwriter).    The purpose of these call spread transactions was to neutralize any eventual dilution which would occur when these bonds eventually converted into stock.

Under the terms of those call spreads, RH completely neutralizes any dilutionthat would occur when the stock prices exceeds $116 and $118.  This was a separate contract with BofA-ML such that even many of the convertible investors are likely unaware of it.

So instead of having dilution at $116 and $118, there is no dilution under the convertibles until the share price exceeds well over $170, even when they are converted.

This type of an option package is certainly not free.  RH paid a huge sum of money to BofA-ML for the massive benefit of incurring no dilution under the convertibles until North of $170. 

But those large payments were made by RH back in 2014 and 2015, such that all of the cost is in the past, while all of the benefit is in the present.   

The full details of these option purchases by RH can be found in the SEC filings.  For example, on the “long” leg of the call spread (“bond hedge”) purchases, the terms are disclosed as follows:13 - 2019 bond hedge

 

 

 

 

14 - 2020 bond hedge

The documents below were from 2014 and 2015. As such I currently believe that most current investors are fully unaware of them.

 

NO DILUTION. WHAT TO LOOK FOR:  In the tables below, look to the column on the far right to see the net impact of the convertible vs. the call spread which was purchased by RH. In each case you will see that “total expected dilution” is zero until share prices well in excess of $170.

 

BOND HEDGE #1 – NO CONVERT DILUTION UNTIL SHARE PRICE OF OVER $171.98

15 - dilution table #1

 

 

 

 

 

BOND HEDGE #2 – NO CONVERT DILUTION UNTIL SHARE PRICE OF OVER $189.00

15 - dilution table #2

 

 

 

Re-evaluating RH’s total debt picture

In a Form 8K released in July 2017, RH included a table showing its total indebtedness following the $700 million repurchase.

Total debt was listed as $1.15 billion, including the $100 million term loan and $650 million of converts.

Some portion of that $100 million term loan has already been paid down. And if Friedman can engineer even a slightly further rise in the share price from here, then the converts will get extinguished (with no dilution until North of $170).

From the Form 8K in July of 2017.

17 - total debt table 

Note:  From the multiple disclosures above, we should assume that the information on total indebtedness in this table above will be subject to significant change in the very near future.

 

 

***   Section 8:  Accelerated vesting. The end game for RH and Friedman.

OK. In this section, your initial reaction is likely going to be one of heated disagreement.  But please hear me out. I have occasionally done some decent work in the past.

In addition to the equity incentive awards above, totaling $100 million, Friedman also has numerous other past incentive awards.  These are also subject to vesting periods and trigger prices at over $100.

After 40 years of working in the retail business, and at the age of 60, Mr. Friedman is now within striking distance of getting all of these option awards to be exercisable and immediately vested.  If this happens, Mr. Friedman then gets to quickly retire with a very solid and immediate nine figure payout.

Keep in mind that just a few months ago that no one would have thought that RH’s share price could possibly by closing in on $100. And yet here we are.

So how does Friedman turn these equity incentives into a nine figure reality in the very near term ?

Again.  Just hear me out.

Step one.  Reduce the share count to a level where the price per individual share is well over $150.  The aggregate value of the company is now increasingly being shifted onto bond holders, and across a smaller and smaller number of common shares.  Again, just use common sense.  As the SHARE COUNT declines, the proportionate SHARE PRICE increases for each individual share.  Duh !

Step two. Conduct this process in a way that minimizes further increases in the enterprise value. Use as much operating cash flow as possible and maximize the impact of prior share repurchases at much lower levels. For example, RH borrowed $600 million to repurchase $1 billion of stock. The stock price then nearly doubled. As such, a very slight increase in debt (ie. EV) was accompanied by a share price that jumped nearly 100%.

In the recent earnings announcement, Mr. Friedman has very explicitly told investors that this is exactly what he is doing and exactly what he will continue doing. Note, this is now turning into a huge pile of cash flow which can be used to buy back more stock or pay down debt.  Here is what Friedman told investors in September:

Our efforts to optimize inventory and reduce capital spending generated $282 million of free cash flow in the first six months of 2017, and we now expect to generate approximately $400 million of free cash flow for the year, which should address any concerns about our balance sheet and debt ratios. We have reinvested the $282 million of free cash flow generated in the first half, and the $263 million of cash and investments on our balance sheet at the beginning of the year towards the repurchase of our stock, which we believe is an excellent allocation of capital for the long-term benefit of our shareholders.

And again, this happened to be the same announcement in which Friedman told investors 4 weeks in advance about the upcoming “repayment in full”of the $100 million in second lien notes.  When that repayment did happen 4 weeks later, the stock quickly shot up 20 points.

Step three.  Even though the price for a single share is now much higher, the enterprise value is actually NOT much higher.  In other words, depending on the eventual share count (and the split between equity vs. debt) a potential acquirer would have no problem paying $100 per share, $200 per share or $1,000 per share, or whatever.  All they care about is the overall valuation of RH.

This is why I referred to Friedman’s approach as being a “stealth/quasi/creeping” going private.  He is shifting the value of the company onto debt holders (and out of the equity markets) with the equity portion being spread across fewer and fewer shares.  When the share count gets small enough (and the share price high enough), he can then sell the entire company if the overall enterprise value merits such a sale.

Again, even when the stock hits $150, the company will certainly be nowhere near 5x as expensive as it was at $30 just 6 months ago.  With the changes in the capital structure, those numbers are no longer comparable.

Remember that RH’s enterprise value is now substantially lower than it was in 2015, even as its performance is on a strong upswing.   RH is also now trading below where it has historically traded vs. forward PE estimates.

So how does Mr. Friedman sell all of RH for an enterprise value North of $3 billion.  (Again, forget about the share price. With a flexible cap structure, the share price  could be engineered to end up $50 or $500 and it wouldn’t matter to an acquirer.)

There are two obvious potential acquirers both of whom could easily afford to snap up RH.  And for each of these parties, their motivation is strategic such that a swing in valuation of even 20-30% in one direction or their other would not be the deciding issue.

A sale to Amazon

I know. I know. It is getting cliché for people to keep speculating that Amazon (AMZN) is going to buy every public company in sight.  But with RH, it actually makes very good sense.

Amazon’s recent purchase of Whole Foods surprised many people. It communicated to all of us a very significant strategic focus for Amazon.  First, Amazon is now actively looking to expand into businesses with bricks and mortar operations. Second, Amazon is focused on acquiring brands and customers in at the high end of the price/quality spectrum.

In both of these respects, RH is identical in furniture to what Whole Foods is in groceries. Amazon’s visible push to the higher end is also why Amazon did not buy Kroger and it is exactly why Amazon would never want to buy Wayfair (W).

I am certainly not alone in sizing up Amazon’s ambitions in expanding into the high end bricks and mortar furniture business.

In May 2017 (just 6 months ago), Fortune Magazine made a great pitch for why Amazon will do exactly that.

 

18 - fortune AMZN

And the Wall Street Journal said the exact same thing in May 2017:

WSJ:  Amazon Makes Major Push Into Furniture

 

 

19 - WSJ Amzon

 

 

 

 

A sale to Williams Sonoma

A potential sale of RH to Williams Sonoma is potentially easier and more interesting, yet many investors are likely tempted to dismiss the idea unfairly.

Williams Sonoma already has an enterprise value of nearly $5 billion, but it has almost zero debt.  As a result, levering up to acquire RH would certainly be quite achievable.

Williams Sonoma owns competitors to RH including Pottery Barn and West Elm.  But sales growth has been consistently stagnant.  While Williams Sonoma has been growing only in the low single digits, RH has been killing it in the low to mid teens in terms of revenue growth (including in the most recent quarter).  The reason why is that RH has built a sustainable brand and a loyal customer base.

As a result, Williams Sonoma would not need to penny pinch and try to lock in a low end valuation in acquiring RH. It could justify paying a premium price simply due to the very obvious synergies that the acquisition would bring.   Both of the companies are headquartered in Northern California, making integration very easy. Both companies distribute fairly similar product lines, which would then allow for the consolidation of third party manufactures, shipping and distribution.  There would be instant cost savings from day one.

As we know, RH CEO Gary Friedman used to be president and COO of Williams Sonoma. When he was passed up for the CEO spot 16 years ago, he then came on as CEO of RH.  And RH has since done quite well in creating a brand and capturing market share.

The one argument I have heard against such an acquisition is that Friedman may now insist on getting that CEO spot for the combined entity post acquisition.   But Friedman is now 60 years old. After 40 years in the business, I think he would be willing to let that honor pass by if it involved him getting immediate vesting on over $100 million in payouts.

Again, I understand that many people are still stuck thinking that RH was “expensive” when it was at $30.  As a result, trying to get comfortable with the notion of a buy out at $150 is going to be tough.

But when we factor in the changes to the capital structure, the improvements in the business and then look at the overall valuation, the specific share price becomes irrelevant.

Either Amazon or Williams Sonoma could easily justify the purchase of RH at current or higher levels.  And (as we have already seen) further financial engineering by Friedman could easily get the share price to over $150 without a commensurate rise in the valuation (“EV”) of the company.

 

 

***   Section 9:  Conclusion. RH is going much, much higher. Very, very soon.

(Note: The short interest of nearly 50% of float is not really part of my bull thesis on RH. But the unwinding of short positions will certainly cause the stock to rise much sooner (and much higher) than it would do otherwise based on just the financial engineering.)

RH’s CEO Gary Friedman began his career in the stock room of The Gap (GPS) in 1977 following a short stint in community college where he reportedly received fairly low grades. Against those humble beginnings, Friedman has been singularly ambitious.

From increasingly senior roles leading Gap, then Williams Sonoma (WSM) and now RH, Friedman keeps climbing the retail ladder.  And when one ladder has no more rungs, he simply switches ladders.

Friedman is now 60 years old and just 6 months ago was given a nine figure incentive package which can be entirely obtained if Friedman can simply financially engineer RH’s share price to over $150.  Within just 2 days of Friedman receiving that award, RH suddenly announced a $700 million share repurchase, which was then fully executed in just a few weeks.

The financial engineering (along with some positive announcement from Friedman) have seen the stock triple in 2017. But the deeply reduced share count means that the valuation is not all that much higher than where it was in April.   At the same time, RHs financial performance has undeniably shown visible improvements which do merit a higher valuation.

There are a variety of levers that Friedman can pull in order to get the share price to $150.

As we saw following a small (and only partial) pay down of the $100 million term loan, RH’s share price is now extremely sensitive to and changes in leverage.  The stock quickly jumped 20 points. As the share price now nears the $116 and $118 conversion prices of RHs two convertible bond issues (totaling $650 million), investors will rightfully begin to recalibrate their view on RH’s share price vs. perceived leverage.  I very strongly suspect that most investors have been totally unaware of the massive “bond hedges” that RH purchased back in 2014 and 2015, which fully neutralize any dilution from the conversion of those bonds into shares until the share price reaches over $170.

As we saw, in the most recent earnings announcement, RH is already “carving out” the calculation of that convertible debt when it describes its total indebtedness.  That was the same earnings announcement that disclosed the intention of paying down the $100 term loan fully 4 weeks before it actually happened.

Disclosure: I am/we are long RH.

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 is long RH and HTZ. The author may transact in various securities mentioned within this article within 72 hours.

 

Short $HIIQ: Fraud penalties to exceed $100 million and undisclosed “domino effect”

Summary

  • New data points: Fraud penalties expected to reach $100 million or more. Other insurers required to cease doing business with HIIQ as part of their fraud settlements.
  • June 2017: HIIQ rejected for key insurance license in home state of Florida as regulator uncovers undisclosed legal actions against HIIQ insiders.
  • HIIQ privately warns of disastrous “domino effect” spreading to other states, causing additional loss of licenses. HIIQ makes no disclosure to investors.
  • Regulatory catalysts now approaching in October 2017.  Insiders have been publicly hyping the stock while simultaneously dumping $50 million in shares.
  • HIIQ is nearly identical to five of my past trades where Craig Hallum was on the other side.  They each plunged by 80-100%. SEC investigations, fraud suits and delistings.

Disclosure:  This article represents the opinion of the author.  The author is short HIIQ.

*** 1 –  KEY STATISTICS

Name:                         Health Insurance Innovations “HII” or “HPIH”

Ticker:                         (HIIQ)

Location:                    Hollywood, Florida

MCap:                         $500 million

Current Price:           $29.90

52w Low:                   $4.00

Avg. Daily Vol:          650k shares ($20 million)

LTM Rev:                    $215 million

LTM Net Inc:              $12 milion

Cash balance:           $27.5 million (≈$2.00 cash per share)

****   2 –  BUSINESS DESCRIPTION

Health Insurance Innovations (HIIQ) develops, distributes and administers individual health and family insurance plans (“IFP”), including short-term medical (“STM”) insurance plans and guaranteed-issue and underwritten Health Benefit Insurance Plans (also known as “hospital indemnity” plans).

HIIQ designs these plans on behalf of insurance carriers and discount benefit providers and then markets them primarily through its internal distribution network and an external distribution network of independently owned call centers.

 

 

*** 3 –  INVESTMENT  THESIS

The theme I will show repeatedly below is one of “delay, downplay, dismiss, deny” which then allows insiders to aggressively dump their shares.

Over the past 7 months, shares of HIIQ rose from below $5.00 to over $35.00 – a seven bagger – despite only marginal apparent improvements in its business.

During this time, revenue has increased slightly, and HIIQ has successfully managed to lower its heavy dependence upon STM plans. But this does nothing to absolve HIIQ of its massive undetermined liabilities stemming from fraud investigations which now span fully 42 states.  And the problems then get worse from there.

HIIQ is now set to quickly plunge by at least 80% to $6.00 or below. Such a decline would really just put HIIQ back to where it was right at the time of the 2016 US election.  (see chart above)  In reality, I strongly expect that there is a high likelihood that HIIQ ultimately plunges to below $1.00 and faces delisting.   No, this is not an exaggeration. Keep reading.

Consider the following:

HIIQ is now facing fraud investigations or cease and desist orders from 42 different states.

Recently emerged data points now indicate that legal liability will be in the range of $100 million or more (as opposed to the mere $1 million number which has been published by certain authors who recently spoke to HIIQ management).

On the heels of these mounting state fraud investigations, in June of 2017 HIIQ was just rejected for licensure in its home state of Florida. In its appeal to the regulator (also from June of 2017), HIIQ then PRIVATELY cited to the regulator the specter of a disastrous “domino effect” from this rejection by which licensing denials will then spread to the other states in which HIIQ does business.

These were the actual very alarming words used by HIIQ to the regulator in June of 2017, yet this impact was not disclosed to investors in the most recent 10Qor anywhere else for that matter.

The scathing letter from the regulator cited multiple reasons for the denial of the license, in direct contradiction with disclosure to investors by HIIQ. For example, as part of its independent background check, the regulator uncovered multiple undisclosed legal actions against multiple HIIQ insiders. When confronted with this by the regulator, HIIQ refused to respond.   Again, HIIQ disclosed something very different to investors.

Delay, downplay, dismiss, deny

HIIQ has retained an expensive law firm and has now submitted, re-submitted and appealed for this license at least 4 times over the course of 2016 and 2017. Now that the final rejection is imminent, HIIQ has somehow tried to suggest that it doesn’t even need such a license in the first place.

As of the most recent disclosure, the Florida regulator is set to publish its final determination in October 2017 (a few weeks from now).  For the sake of completeness, I have already sent a copy of this entire article to the Florida regulator.

The slew of massive legal and regulatory problems facing HIIQ is set to unravel in the very near term. There are multiple near term catalysts. The most visible catalyst is coming in just a few weeks in October 2017.

HIIQ has repeatedly attempted to suggest that it is actually some other party (such as HCC) that is being investigated or is at fault. Yet anyone who reads the actual legal filings can immediately see otherwise. In the fraud complaints from 42 state governments, the repeated theme is that HIIQ has engaged in fraudulent sales practices while operating without a license.  And now HIIQ has brazenly attempted to suggest to investors that maybe it just doesn’t need such licenses at all.

And here is where it gets really interesting:

Even as HIIQ passionately encourages investors to buy, the insiders have been aggressively dumping their own shares.  So far in 2017, HIIQ insiders have dumped millions of shares taking in over $50 million.  Keep in mind that just a few months ago, the market cap of the entire company was less than $200 million.  In November off 2016, the market cap was just $70 million.

Notice that insiders were aggressively dumping a huge volume of shares even when the price was more than 50% lower than the current level, at just $14.   Selling has come from all corners, including the founder, the CFO, CTO and the CEO of its Healthpocket division.

History of insider sales:

Delay, downplay, dismiss, deny

In fact, now that the legal consequences are rapidly closing in, management’s actions are becoming downright blatant. Last week (on Tuesday September 5th), after the stock had suddenly dropped from $37 to below $30, Craig Hallum put together a hastily arranged conference call for management to reassure investors.  As expected, the stock briefly rebounded.  Just hours after this impromptu call encouraging investors to buy, multiple members of management began disclosing additional large share sales by insiders, quickly amounting to $1.5 million over just two days.

 

New SEC filings were then released in the after hours beginning on September 5th, which continued to the end of the week:

(Sheldon Wang is HIIQ’s CTO. The full list of Form 4 sales by HIIQ insiders can be found on Edgar)

                                        

As you read the magnitude of the problems below, keep in mind that HIIQ has a cash balance of just $27.5 million with which to run its entire business and then deal with all of these impending liabilities.

The recently revealed data points indicate liability of $100 million or more.

So you do the math !!

It will quickly become clear why I am saying that HIIQ has the potential to drop to below $1.00 and face ultimate delisting.  Either way, given the unfolding of the events above, a $6.00 share price will likely prove generous by the time Florida makes public its decision in just a few weeks.

This dire prediction for HIIQ is pretty much in line with what I had predicted on five prior Craig Hallum trades. For reference, the five companies were Unipixel (UNXL), Neonode (NEON), Erickson Air Crane (EAC), TearLab (TEAR) and Plug Power (PLUG).

Just like HIIQ, each of these past stocks had quickly spiked by 200-800% following gushing support from Craig Hallum. As the share prices spiked, large share sales or equity offerings then followed. As soon as I exposed their terminal underlying business problems, each of these stocks immediately plunged by 30% or more. Each of the stocks then went on to by implode 80-100%, just as I predicted.  Among these five companies, we then saw various combinations of SEC investigations, fraud lawsuits, bankruptcy and/or delisting.  I am specifically including below my five past articles which were specifically focused on past Craig Hallum trades on similar toxic companies. I would strongly encourage readers to have a look. The similarities to what we see with HIIQ should become 100% obvious.

***   4 –  LOOKING AT FRAUD INVESTIGATIONS FROM 42 DIFFERENT STATES

Delay, downplay, dismiss, deny.

HIIQ is currently facing a tidal wave of fraud investigations, lawsuits and cease and and desist orders which now already extend to at least 42 states (that we know about so far).

In March of 2016, here was the initial action taken by the state of Arkansas Insurance Department following a sting operation which revealed unlicensed insurance sales in Arkansas. During additional calls,  “several” company representatives misrepresented the insurance products in an attempt to sell insurance plans, not realizing that the person calling was actually The Arkansas Insurance Department.

Read this screenshot closely.

Within 60 days, in May of 2016, HIIQ had already received another cease and desist from the State of Montana, requiring the company to immediately cease and desist from selling insurance in the State of Montana.

Delay, downplay, dismiss, deny.

In July of 2016, HIIQ filed a very lengthy 8K announcing the appointment of Gavin Southwell as President and Josef Denother to serve as COO.  Within the 8K, HIIQ spent 4 pages elaborating in deep detail the most minute details of the terms of employment for these two.  And then buried in the 8K, 4 pages in, HIIQ included a single small paragraph disclosing the commencement of a multi-state investigation being headed by the State of Indiana.  And now finally the company disclosed the Arkansas and Montana legal actions from months earlier. But by this time, anyone who actually made it through to page 4 of this 8K could see that the investigations had expanded to include Arkansas, Florida, Kansas, Montana, Ohio, South Dakota, and Massachusetts.

When HIIQ ultimately chose to provide more detail on these investigations in March of 2017, it attempted to portray its own role as being just one target among many players. Here is how HIIQ described the Montana fraud complaint. Keep reading and decide for yourself if this is an accurate representation or if it is wildly misleading.

HIIQ specifically emphasized that it was “among more than two dozen separate parties named”.  But the reality is that the other parties being named in this Montana action were largely being named as a result of the fact that they were doing business with HIIQ.

According to Montana:

These policies are routinely sold though misinformation and deception at the point of sale by individuals not properly licensed or appointed in Montana to conduct this insurance business.

“The HII scheme”

In fact, throughout this Montana action, the Montana State Auditor refers to the fraud directly as “the HII scheme”.  The Montana fraud complaint includes only two graphics throughout its 25 pages. Both of these graphics specifically map out HIIQ’s role in the scheme, without any mention whatsoever of the “two dozen” other players emphasized by HIIQ.

Here are the ONLY TWO GRAPHICS from the Montana fraud complaint, both of which focus ONLY on HIIQ.

Delay, downplay, dismiss, deny.

***   5 –  NEWLY EMERGING DATA POINTS:  LIABILITY OF $100+ MILLION  

As various settlements from involved parties start to dribble out, we can begin to find data points to help us either confirm or contradict the disclosures from HIIQ.

For example, from recent settlement agreements for other insurers named in the investigations, it was specific term of the Consent Order was that it was “contingent upon Unified ceasing to sell through HII”.

From the Kansas Consent Agreement with Unified Life Insurance:

In a recent article on Value Investors Club, the author had stated that HIIQ has also ceased doing business with HCC Life Insurance.  He seemed to think that this was a good thing.  But it now strikes me that this termination was more likely result of the multi-state investigation being headed by the State of Indiana naming HCC for its involvement with HIIQ.

 This is really, really bad.

And then it gets even worse.

Multiple new data points relating to multiple states have recently emerged (including using HIIQ’s own disclosure).  These now indicate that legal liability could be in excess of $100 million (and potentially much more).

In the recent 10K, HIIQ noted that a penalty of $100,000 to $315,000 was “probable” in the state of Montana. Such a low penalty caused the VIC author above to be optimistic that total penalties would only be around $1 million.

Here is the disclosure from HIIQ:

But in the Montana complaint filed by the Commissioner of Securities and Insurance (“CSI”), we can see that during the investigation period, HII is only said to have brought in revenues of $503,800.

In other words, in its own estimation, it is “probable” that HIIQ will be forced to pay in the area of 20-60% of its revenues that were generated in Montana. 

Based on the past disclosure patterns from HIIQ, I believe I have a right to be suspicious that the estimate provided by HIIQ is still too low.

This suspicion is entirely borne out by looking at the next settlement (which HIIQ is obviously well aware of).

In the recent 10Q, HIIQ made reference to a recent settlement by a carrier for “the same set of allegations” by the Massachusetts Attorney General (“MAG”).  HIIQ did not name the party by name and it stated that it was too early to predict any loss as it might apply to HIIQ.

In fact, HIIQ suggested that there may not be any loss at all !!

 

Delay, downplay, dismiss, deny.

Actually, a quick legal search reveals that the party who settled was Unified Life, which has been named alongside HIIQ in fraud complaints in other states.  In fact, as part of Unified’s fraud settlement in Kansas (“KID”), an explicit term of the consent agreement was that it was “contingent upon Unified ceasing to sell through HII”.

Once we know this information, we can see from Unified’s settlement with the MAG that it actually paid more than 100% of all revenues it generated in the state of Massachusetts.

This settlement of nearly identical charges included Unified directly reimbursing residents for 70% of all premiums paid plus 5% interest per annum !!

From Unified’s settlement with the Massachusetts AG:

Over the various time periods in question, HIIQ has generated over $300 million in total revenues. Feel free to make your own calculation on how to apportion these revenues across the 42 states that are currently investigating HIIQ and according to what portion of the revenues are applicable to the various investigations.

What you will find is that even by stretching one’s optimism and creativity, it is very difficult to come up with a liability that is less than $100 million, even using very conservative estimates.

As of Q2, HIIQ had just $27.5 million in cash.  I expect that HIIQ will need to conduct a large equity offering in order to meet these liabilities.  Even with its lofty current market cap of $500 million, this would present a meaningful challenge.  At much lower market caps (such as the $200 million where HIIQ was just a few months ago) an adequate equity offering becomes almost impossible.

But clearly HIIQ has the full support of Craig Hallum who continues to enthusiastically recommend the stock despite the obvious problems.

***  6 –   THE SCATHING REJECTION FROM FLORIDA’S INSURANCE REGULATOR  

Just recently, in June of 2017, HIIQ was rejected by the Florida state insurance regulator over its application for a license to conduct business as a 3rd party administrator in Florida.  HIIQ then filed an appeal, also in June of 2017.

Below is a screenshot showing how HIIQ chose to disclose this event to investors in the recent 10Q. In short, we are supposed to believe from the disclosure that it is just “no big deal”.

Apparently, after the notification of fraud investigations by 42 states claiming unlicensed selling, HIIQ now tells us that it is taking a “prudent” approach and seeking a license in Florida.  HIIQ states that it was only rejected because “the company had not yet provided all information required”.  HIIQ notes that the denial is under appeal, set to be finalized in October.  In fact, maybe the Florida OIR won’t even require a license at all !!

With such muted and understated disclosure, it is no surprise that seemingly no one has even noticed this event.

Delay, downplay, dismiss, deny.

But actually, the rejection letter from the Florida OIR paints a dramatically different picture.

From the Florida OIR:

The references above to “material errors and omissions” refers to something bad.  In fact, it is really, REALLY bad.

On its application to act as a 3rd party administrator, Florida asks the applicants if they have been a party to any civil actions over the past 10 years involving dishonesty, breach of trust, etc.

The HIIQ insiders repeatedly answered “no” to those questions.  But then an independent background checkby the Florida regulator uncovered multiple such undisclosed legal actions against multiple HIIQ insiders. This includes both the CFO of HIIQ (Michael Hershberger) as well as its founder (Michael Kosloske).  Even when pushed by the regulator, HIIQ refused to supply information over these undisclosed legal actions.

Note that together, Mr. Hershberger and Mr. Kosloske have sold over $40 million in HIIQ stock over the past few months.

Againfrom the Florida OIR:

As per the above rejection letter from the Florida regulator, even when confronted with the undisclosed legal actions against multiple insidersHIIQ refused to respond or provide the information required.

***  7 –   IMPLICATIONS OF REJECTION IN FLORIDA (ACTUAL VS. DISCLOSED)  

As we can see in that rejection letter above, HIIQ has applied, re-applied, and then filed extended appeals at least 4 times over the course of 2016 and 2017 in order to obtain this license.  HIIQ has also hired an expensive law firm in order to try to boost its cause.  Yet as the rejection date is now just weeks away, HIIQ has attempted to change its story, suggesting that maybe it just doesn’t need this license at all.

By reading the above rejection letter in full, you will almost certainly come to the conclusion that there is effectively a zero percent chance of HIIQ getting this license in Florida. (Separately, for the sake of completeness, I have sent a copy of this article to the listed email address of the Florida regulator at Carolyn.Morgan@FLOIR.COM).

As we saw above, HIIQ’s disclosure of the Florida rejection was so muted and understated in the 10Q that most investors probably never even saw it.  Those that did would have understandably come to the conclusion that it was just no big deal.

Delay, downplay, dismiss, deny.

But the private communications between HIIQ and the Florida regulator were not disclosed to investors.  Those statements, IN HIIQ’s OWN WORDS, paint a picture which is absolutely catastrophic.

Below is a screenshot showing HIIQ’s own language (filed by their law firm) describing the dire consequences that HIIQ faces if it is rejected by Florida.

As shown, following its rejection for licensure as a 3rd party administrator in Florida, HIIQ / HPIH wrote a letter of appeal to the Florida regulator dated  June 16, 2017.  In that letter, HIIQ warned that a rejection in Florida would comprise a “reporting event”, obligating HIIQ to inform the other states in which it does business.  In HIIQ’s own words, this would then trigger a “domino effect” which could result in its losing licenses in the other states where it does business.  In other words, according to HIIQ itself, the consequences of a regulatory rejection in Florida will be catastrophic.

(Note that in HIIQ’s SEC filings, the name of HIIQ and its VIE “HPIH” (“Health Plan Intermediaries Holdings”) are used interchangeably.)

In HIIQ’s own words: 

To say that the interests of HPIH as an entity would be substantially affected is a radical understatement.

Clearly all of this is extremely material information that investors should have been made aware of. But rather than disclose this information to investors, management has dumped over $50 million in stock this year, including just last week.

*** 8 –   RESASSUING INVESTORS WHILE AGGRESSIVELY DUMPING SHARES 

By now you should start to see what I mean by delay, downplay, dismiss, deny.

Just last week, HIIQ conducted an impromptu conference call to investors, arranged by Craig Hallum. Over the prior two trading days, the stock had dropped from $37 to below $30. But because of this investor call, the stock price quickly rebounded.

As shown earlier in this article, almost immediately after the investor call boosted the stock last week, insiders began quickly disclosing more sales, amounting to $1.5 million across just two days. Sellers included the CFO, the CTO and the CEO of HIIQs Healthpocket subsidiary.

Below is a table showing the insider sales that have occurred just during 2017. A full list of Form 4 filings can be found on Edgar.

During 2017 alone, insiders have raked in $50 million from selling stock.  Earlier this year, the entire company a valued at just $200 million.  In November of 2016, the entire company was worth just $70 million.

*** 9 –  THOUSANDS OF PREVIOUS WARNINGS ABOUT FRAUD AT HIIQ

Realistically, no one needed any legal databases or Bloomberg to figure out what was going on with HIIQ.

Here is a great hint for those of you looking for compelling short ideas.  Google the name of a company along with the word “fraud”. Any time you get more than 40,000 immediate hits, you likely have a very safe short.  Feel free to try this test with HIIQ before proceeding.

Keep in mind that when parties are accused fraud, they very seldom raise their hand and admit it.  The most common response is to put forth repeated denials for as long as possible.

Even before we look at the explicit fraud investigations by 42 different state governments, we can see thousands of very explicit complaints by individual consumers from all across the country.

Regardless of location, consumers across the US repeatedly use words like “fraud”, “scam” and “lies”.

Based on this overwhelming consensus from consumers, HIIQ has actually managed to obtain the ultra-rare “F rating” from the better business bureau.

On the recent investor call, Craig Hallum posed a layup question to HIIQ management, effectively stating, “tell us how bogus and erroneous the BBB complaints are”.  HIIQ responded by attempted to convince investors that the BBB is a corrupt entity which has falsely listed more than 80% of the complaints on its site.  HIIQ also tried to state that the huge volume of online fraud complaints are simply the result of the fact that HIIQ does a high volume of business, such that a large number of complaints should also be expected.

Here are the links so that you can check their claims for yourself.

From the BBB page on HIIQ:

At just this one site alone, HIIQ has received 651 complaints.  Out of the 93 total customer reviews, 90 are negative.  This is quite obviously not simply a question of  “high volume”.

Yet even aside from the “corrupt” BBB site, every other site I could find also contains very similar fraud complaints from different consumers in different states across the country. The reviews are again overwhelmingly negative, regardless of which site is reporting.

This includes:

ComplaintBoard.com

RipOffReport.com

PeopleClaim.com

MyThreeCents.com

Here is a recent screenshot of multiple consecutive reviews from qn entirely different site called ComplaintBoard.com.

Next, here is the rating page and customer review profile for PeopleClaim.com, which is also separate from the BBB. Again HIIQ receives the ultra-rare “F rating” along with across-the-board ratings of 1 star out of 5 (the lowest rating possible).

Before proceeding further, take a few moments to click on the links above and judge for yourself.  When it comes to HIIQ, the caustic consensus among consumers from all across the country appears to be entirely similar regardless of their location.

 

*** 10 –    MY PAST ARTICLES ON “CRAIG HALLUM SPECIALS”

We are currently living through one of the biggest bull markets in history.  Stocks of all shapes and sizes continue to surge higher, even on bad news.

Yet somehow I have been able to repeatedly identify dozens of stocks which then quickly imploded by 80-100%.  SEC investigations, fraud suits and de-listings followed soon after.

One of my better sources of compelling short ideas (impending implosions) has been stocks which are being aggressively recommended by Craig Hallum despite the presence of very obvious problems.

Each of the stocks below soared by 200-800% following aggressive and repeated recommendations by Craig Hallum.

In each case, the underlying business problems were not only terminal, but they should have been entirely transparent.  Not surprisingly, these companies often needed money and Hallum ended up making millions of dollars in investment banking fees across these companies.

For precisely all five of the Hallum trades below, they quickly imploded by at least 30% as soon as I exposed them.  They then went on to implode by 80-100%, just as I had predicted.

The repeated theme was that even as the share prices soared ever higher, Hallum would just ratchet up the share price target again and again.  After insiders or the companies sold shares, the share price then began its inevitable implosion.

For example, Hallum’s escalating series of buy recommendations helped to take fraudulent Unipixel (UNXL) from $5.00 to over $40. Hallum’s final target before the implosion had been raised to $58.00. After I exposed the fraudulentcompany, the stock ended up getting de-listed and now trades for just pennies.  But not before Hallum made millions by helping Unipixel sell shares to investors.

Craig-Hallum Raises PT on Uni-Pixel (UNXL) to $58

Uni-Pixel Announces Pricing of $38.2 Million Public Offering of

Common Stock

Ex-CFO Charged With Deceiving Uni-Pixel Investors

At the time when I wrote about Neonode (NEON), Hallum’s repeated target hikes had seen the stock go from $2.00 to over $8.00. Hallum’s final target was $10.00 before Neonode imploded to $1.00 when Hallum’s predicted business developments failed to materialize.  I wrote Neonode when the stock was at $7.00. As I highlighted in my article, prior to the implosion Neonode conducted a huge secondary offering in which nearly all proceeds went to selling insiders.

NEONODE ANNOUNCES PRICING OF PUBLIC OFFERING OF COMMON STOCK

When I wrote about Erickson Air Crane (formerly EAC), Hallum’s support had seen the stock quadruple to as high as $28.00.  EAC was visibly defunct and was being stripped by insiders. On the day of my article, the stock plunged by more than 30%.  It quickly went on to implode to zero once it filed for bankruptcy.  But not before various insiders unloaded at very beneficial prices.

Mystery silence at Erickson Inc. ends with bankruptcy filing

Plug Power was a very obvious promotion when I exposed it at $8.00.  Craig Hallum was again a strong supporter.  The company was also in dire need of cash.  Following my article, the stock plunged to $1.00, but not before it had already raised $22.4 million from investors.

PLUG POWER INC. ANNOUNCES $22.4 MILLION REGISTERED OFFERING

TearLab (TEAR) was another defunct business in dire need of cash which was being aggressively and repeatedly recommended by Craig Hallum.  With the benefit of Hallum’s support, TearLab’s share price eventually reached $18.00.  When I last wrote about TearLab, the stock was still at a pre-split price of $13.00. Since that time, the stock has fallen by 99.9% as its nonsensical business predictably failed to materialize.  Even after a large reverse split, the stock sits at just $1.00. But as always, TearLab was able to raise large sums of cash from equity sales before imploding.

TearLab prices $35.1 mil public offering of common stock

Please note:  There is a very good reason why I have taken the trouble to include these links to my precedent experiences with “Craig Hallum specials”.  Please take just a few minutes to read my analysis of these situations, which predicted their obvious impending implosions.

*** 11 –   CONCLUSION  

I will sum up my thesis on HIIQ as follows:

Delay, downplay, dismiss, deny, then dump millions of stock.

As soon as this latest fluff trade falls into the single digits, you should expect to hear me publicly say “I told you so”.

 

 

 

Disclosure: I am/we are short HIIQ.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.

$HTZ Shares Of Hertz Could Still Double (Or More) From Here

Summary

  • Quite suddenly industry insiders, analysts and media are recasting beleaguered “car rental” plays into lucrative “fleet management” plays, CRUCIAL to the futures of Uber/Lyft.
  • Icahn owns 35% of HTZ and is major Lyft investor. Icahn paying huge premiums to acquire additional targets across rental, ride share, service and parts.  “Vehicles As A Service”.
  • Short interest at HTZ just hit 61.9% of float. Short interest now EXCEEDS effective float by millions of shares. Not enough shares for shorts to readily cover.
  • As we saw with RH and WTW, shares of highly levered and heavily shorted stocks can quickly triple when even a very mediocre improvement changes the bear thesis.
  • With Herbalife, Icahn has shown that he iswilling and able to play and benefit from a short squeeze.  Icahn is now showing a paper profit onHerbalife of $500 million.

Note:  This article is the opinion of the author.  The author is long HTZ.

Recent developments

On Tuesday, Hertz Inc (HTZ) released Q2 results. As expected, the numbers were grim as ride hailing services continue to steal customers and revenues from traditional car rental companies.  On the conference call, newly installed CEO Kathryn Marinello was making an obvious effort to “under promise, then over deliver”, in sharp contrast to multiple years of unfulfilled hype from her predecessors.

Here is what I suggest.  First, read my analysis below. Then go back and re-listen to the Q2 conference call, keeping an ear open for a number of very subtle (and under hyped) clues. Most of these were not even mentioned until the Q&A at the very end:

  • fleet management, fleet management, fleet management
  • huge surge in rentals to ride hailing drivers
  • autonomous vehicles
  • artificial intelligence
  • “telematics and car sharing technology”
  • large increases in ownership by 5% holders

Also on Tuesday, Uber announced that it would be terminating its car leasing program which was providing cars to Uber drivers with poor credit.

Report: Uber Getting Out Of The Car Leasing Business After Losing $9K Per Car

The announcement highlights the need for “transport tech” leaders (including ride hailing and autonomous tech) to focus on what they are good at (i.e. the technology, not the vehicle management).   It’s not just that Uber was losing tons of money on this program. The real crisis was the Uber actually had no idea how much money they were actually losing. Uber was originally estimating that losses were running about $500 per car. Instead, the real number was roughly $9,000 per car!

This is why Uber, Lyft, and Apple are already scaling up their programs to use Hertz vehicles and let Hertz handle the fleet management.

Investment summary

Apple, Google, Uber and Lyft have been pouring billions into their quest for ride hailing and autonomous vehicles.  Uber alone is on track to lose $3 billion just in 2017 alone. Multi billion dollar losses are just the price of admission into this burgeoning market.

Yet none of these players has any appetite to undertake the ownership, management, repair and logistics of fleet management.

As these giants jockey for position in this transportation gold rush, Carl Icahn is aggressively pursuing the strategy of “selling shovels to the gold miners”.

In various public statements, Icahn has made it very clear that there is a new paradigm shift in how people are getting from one place to another.  Icahn is clearly NOT betting that the current car rental model is going to rebound in its current form.

Instead, Icahn is building a nationwide “Vehicles as a Service”  (“VaaS”) platform with Hertz (HTZ) at its core. The purpose is to provide fleets and fleet management to the new transportation providers in ride hailing and autonomous vehicles.

Even as Hertz’s share price was plunging to new lows, Icahn more than doubled his stake, buying 16 million more shares at an average of $23.78 in November.  Icahn now owns 35% of Hertz.

Over the past 3 years, Icahn has been spending billions, paying huge premiums to snap up numerous other companies from all parts of the fleet management spectrum, including:  car rental (fleet management), ride hailing, auto parts and auto servicing.

The headlines over the past 3 years illustrate Icahn’s “Vehicles as a Service” strategy centered around Hertz .

Date Sector Title
Aug 20, 2014 Fleet mgmt Carl Icahn Takes 8.5% Stake in Hertz
Feb 10, 2015 Auto parts Carl Icahn Adds To Quiet Empire With $340 Million Auto Deal (Beck/Arnley Worldparts)
May 15, 2015 Ride share Carl Icahn Calls His $100M Lyft Investment a ‘Bargain’
May 18, 2015 Multiple What’s up with Carl Icahn’s sudden car obsession?
Oct 8, 2015 Ride share Lyft partners with Hertz to offer its drivers affordable rental rates
Dec 30, 2015 Auto parts Pep Boys agrees to be bought by Icahn for $1 billion
Jan 25, 2016 Autonomous GM invests $500 million in Uber rival Lyft
Sep 12, 2016 Various Carl Icahn’s Federal-Mogul bid likely part of bigger plan
Nov 8, 2016 Fleet mgmt. Carl Icahn doubles his stake in Hertz as stock plunges
Jan 23, 2017 Auto parts Carl Icahn Will Pay Nearly $300 million for Federal Mogul
June 2, 2017 Service Leesburg-based Precision Auto Care jumps 90 percent on Icahn deal
Jun 4, 2017 Service Carl Icahn plans to acquire thousands of auto-repair shops
Jun 27, 2017 Autonomous Apple Autonomous Car: Hertz To Manage The Self-Driving Fleet

Ultimately, Icahn’s VaaS strategy means that whichever emerging technology wins out in the next few years, Ichan (and Hertz) will be poised to be the most comprehensive and integrated provider of fleets and fleet management.

So rather than being defeated by ride hailing apps such as Uber and Lyft, Icahn is positioning Hertz to be the key service provider to BENEFIT from the rise of Uber and Lyft.

In just the past two weeks we have started seeing industry journals, sell side reports and mainstream media articles which are doing a 180 degree pivot on the outlook for car rental (now known as “fleet management”) providers.  Details of these reports and articles are included below.

This new (and more forward looking) thesis is a radical reversal from the draconian extinction thesis which has led Wall Street to place massive short bets against Hertz.

But the extended negative sentiment has already pushed Hertz’s share price down by 90% in 3 years. The most recent “Sell” rating (from Barclays) sent Hertz tumbling by 30% in two days on massive volume. Short interest currently sits at 61.9%.

But in fact it is actually much worse than this.

Beyond the stated short interest on Bloomberg, the true effective float has shrunk to just 22.3 million shares vs. a current 33.4 million shares short. There are simply not enough shares to allow shorts to readily cover.  This math and its components are illustrated below.

So how is the bear thesis suddenly changing?

The severe bear thesis has two components, both of which are quite obvious. First, it is assumed that ride hailing companies (Uber/Lyft) will simply put the rental companies out of business by stealing passengers and revenues. Second, it is assumed that rental companies will be severely impacted by a glutted used car market when they attempt to sell their car inventory. This has been a very visible phenomenon over each of the past few quarters (including the just announced Q2).

But now Hertz is gradually being transformed. Rather than being a competitor to Uber and Lyft, Hertz will be a SUPPLIER to Uber and Lyft and will benefit along with their rising dominance.  (If you re-listen to the Q2 conference call, this should become apparent.)

Passengers will still be using Uber and Lyft to book rides which are fast, flexible and convenient.  But they will be increasingly riding in a Hertz car.

Following his initial investment in Hertz, Icahn invested $100 million in Lyft.  Shortly thereafter, Lyft began a program where Lyft now pays up to 90% of the cost for its drivers to rent cars from Hertz, rather than driving their own cars. This allows drivers flexible use of a vehicle whenever they want at almost no cost and with zero responsibility for depreciation or maintenance as long as their rider targets are met.  Shortly thereafter, Hertz began a different program to rent cars to Uber drivers as well.  Now that Uber has terminated its own leasing program, it will need to figure out a quick and easy substitute (such as Hertz).

When you re-listen to the Q2 conference call, you will hear that there has been a very steep increase in ride hailing rentals, up from nearly nothing a year ago. Virtually no attention was given to this development on the call.

Furthermore, as Apple, Google, Uber and Lyft seek to eventually eliminate drivers completely by using autonomous vehicles, their need for fleet management becomes even more critical (because there will be no more drivers to supply their own cars).  Autonomous vehicles are still a few years away. But even as these programs develop in the test phase, they will need fleets of thousands of vehicles across the country.

For Hertz, this new “fleet management” paradigm destroys both legs of the current short thesis. Here is why:

By providing the cars to Uber and Lyft, Hertz will increasingly be able to claw back a substantial portion of the revenues which would otherwise be lostas passengers shift towards Uber/Lyft rather than renting their own cars. Yes, these revenues are lower margin that corporate customers. But they allow Hertz to get marginal revenue from cars which would otherwise be sitting idle.

Second, it also means that Hertz can greatly extend the useable life of its car inventory rather than being forced to dump its inventory at distressed prices into a glutted used car market.  “Car rental” customers typically expect a car that is brand new or perhaps one to two years old.  But both Uber and Lyft allow their drivers to use cars in good condition which are more than 10 years old.  Hertz is already in the late stages of “right sizing” its fleet. Once this is done, the pain from inventory sales should get significant relief going forward.

And as we will see, the Hertz programs with Lyft and Uber are just one element of Icahn’s much wider assembly of fleet management via his VaaS acquisitions.

With Hertz trading down by more than 90% in 3 years, Ichan is now conceivably in a position to acquire the remainder of Hertz outright. The remaining 65% of Hertz’s equity is now valued at just $700 million.

Alternatively, each of Apple, Google, Uber and Lyft are now so enormous that they could easily take a $300+ million stake in Hertz just to secure their future access to the fleet management. Such an investment would be tiny for any of them.

In the past, Icahn has repeatedly taken large stakes in out-of-favor companies which were highly levered and heavily shorted.  When his investment reduces the outstanding float of the heavily shorted stock, the supply and demand imbalance causes the shares to rise almost automatically.

As Icahn repeatedly increased his stakes in embattled (and heavily shorted) Herbalife (HLF), that stock rose by 70-100% from the time of his initial investment.

As with Herbalife, Icahn started small and then made a large increase in his stake.  Also like Herbalife, Icahn obtained substantial influence over Hertz via multiple board seats.

Hertz is highly levered. Even just a mediocre re-rate of its business prospects (just a slight boost to enterprise value) will result in a massive spike in the equity value. The high short interest will then further turbo charge that rise.

But, in fact, judging by the significant shift among sell side and mainstream media sources, we could be due for a re-rate that is much larger than just “mediocre”.

During 1H 2017, shares of Restoration Hardware and Weight Watchers (WTW) each tripled and quadrupled despite very “mediocre” improvements in their business outlooks and results.  The reason for the meteoric share price spikes was that both companies were highly levered and heavily shorted. Again, even just a very mediocre re-rate of their business prospects caused their share prices to triple and quadruple.

Given the significant shift in the business prospects for Hertz, seeing the share price triple or quadruple should come as no surprise in the near future. 

This is why Icahn was more than happy to double down at $23.

***   1.  THE BEAR THESIS ON HERTZ HAS REACHED ITS NADIR

Shares of Hertz are now down by 90% in three years. The entire market cap of Hertz is now down to just $1.2 billion.  Icahn already owns 35%.

On July 31, Barclays put out an extremely bearish sell note on Hertz. But in reality, all the Barclays note did was simply amplify the bear thesis that had already been widely disseminated in the market for the past year.   Barclays predicted that Hertz’s stock was due to fall by a further 50% from its then level of just under $18. In just two days, Hertz stock fell by 30% on 40 million shares of volume. Short interest now stands at a staggering 62.0% of float.

Here are the short interest data:

***  2.   BUT THE HERTZ INVESTMENT THESIS HAS NOW CHANGED

But suddenly, in just the past week, other sell side analysts began waking up to a new paradigm for the former “car rental” companies.  These “rental companies” are now being re-cast as “fleet management” plays which are actually CRUCIALto the future ambitions of ride hailing (Uber/Lyft) and autonomous vehicles (Apple/Google).

Hertz share price has been battered due to poor financial performance and negative sentiment towards the future.  But this share price outlook could change sharply.

As we have already seen, private companies like Uber and Lyft are being awarded PREMIUM valuations despite continued large financial losses.  The only thing that matters is securing market dominance in this transportation gold rush.  Once investors realize Hertz’s emerging positioning in this new market, its distressed valuation could easily flip to a premium valuation.

The only thing that is really necessary is just a change of popular sentiment.

Following the bullish report by JP Morgan last week, mainstream media outletsare now jumping on the bandwagon to hype the prospects of this new distributed transportation paradigm.

A few weeks ago, this sort of positive attention on “car rental” companies was unthinkable. But now such attention is becoming popular.

Aug 4th – Motley Fool – Why Hertz Global Holdings, Inc. Stock Jumped on Friday

Aug 6th – Street.com – Hertz and Avis can expect a boost from autonomous vehicles

Aug 7th – Seeking Alpha – Hertz: Reversing My Opinion Going Into Q2

Aug 9th – InvestorPlace – Surprise! Hertz Global Holdings, Inc (HTZ) Might Survive Uber

As Hertz transforms itself into a “fleet management” company, it will let other players (such as Uber, Lyft, Apple, Google) interact with the end passenger.  Regardless who is booking the ride for the passenger, the passenger will still end up in a car that is ultimately supplied by Hertz. The transition into autonomous vehicles will only accelerate this trend.

Not only will Hertz get to claw back revenues which would otherwise be lost, but it can also make drastically longer use of its car inventory.  Since Uber and Lyft allow the use of much older cars, Hertz can greatly extend the life of its car inventory rather than repeatedly dumping 1-2 year old cars into a distressed used car market.

Requirements for Lyft vehicles vary by state, but range from as old as 2002-2007.

On August 4th,  JP Morgan revealed the first hint of the new investment paradigm from a sell side analyst.  Despite his neutral rating on Hertz, the stock jumped 10% that day.

Analyst Samik Chatterjee pointed out that incumbent car rental players would have a distinct advantage over potential new entrants into the fleet management business and that the overlap between rental and ride shares is set to expand:

But actually it was a few days earlier, on August 2nd , that the lead story Auto Rental News was titled: “Own the Fleet, Own the Future”. This article noted that:

In these conversations surrounding new transportation paradigms, fleets have been off the public radar until recently. What those in fleet know, the rest of the world is finally understanding: If you own the fleet, you own the future.

Why? First, a future with fewer personally-owned vehicles means someone will have to own and manage this new ecosystem.

Fleets are playing a part in shared-use scenarios, which were at one time only found in traditional consumer carsharing applications. Using telematics and carsharing technology, these new systems are forming to serve residential and business complexes, downtown offices, universities, municipalities, and whatever type of community needs personal mobility for their members and workers.

JP Morgan notes that the gap between rental cars, ride share and autonomous vehicles is now shrinking, “making them one and the same”.

Hertz already has in place programs to provide rental cars to both Uber and Lyft drivers.  In fact, Icahn’s Lyft is now paying Hertz up to 90% of the cost of a rental for Lyft drivers when they meet minimum ride requirements.

What this means is that a Lyft driver can use a Hertz car (rather than his own) at almost no cost. He gets unlimited miles, the insurance is included and he bears no cost of depreciation or maintenance.

Here is the current offer being made to Lyft drivers. Keep in mind that Lyft is the one paying the fully agreed price to Hertz.

Again, remember, Hertz is receiving the fully agreed price for the rentals above. The subsidy is being provided to the driver from Lyft.

 

***   3. HERTZ IS NOW THE CENTER HUB OF ICAHN’S “VEHICLES AS A SERVICE” PLATFORM

Ride hailing platforms are undeniably faster, easier, cheaper, more convenient and more flexible than renting a car. So until now, Icahn’s decision to double down on an imploding car rental chain was puzzling.  After all, the consensus view on heavily shorted Hertz was that “car rental” is quickly going the way of the Yellow Pages and the printed newspaper. Ultimate failure was certainly viewed as a question of “when” not a question “if”.

So why is Icahn so content with his current paper loss of $1 billion on Hertz?

The answer is that $1 billion is actually a tiny price to pay for a controlling position in the new transportation paradigm.  In just 2017 alone, Uber is on track to lose a staggering $3 billion.  Eventual profitability for Uber is nowhere in sight.

There are now many players vying for the future of how to transport people around. Giants like Apple, Google, Uber and Lyft have each been competing to throw BILLIONS of dollars into their transportation efforts with absolutely no need to make near term profits.

Regardless of who eventually wins this transportation gold rush, Carl Icahn will be “selling shovels” to them all, winners and losers alike. 

Once you review the timeline of Icahn’s involvement in this space, this strategy becomes entirely obvious.

Icahn began investing in Hertz in 2014, when the share price was still over $100. In 3Q 2016, a steep earnings miss sent Hertz’s share price into a tailspin, plunging by 35% from its then level of $35.  Icahn immediately bought 16 millionmore shares at an average of $23.78, more than doubling his total stake to 29.3 million shares.  Icahn is now the largest shareholder of Hertz with a 35% stake.

Both of Hertz’s bonds and shares have been under tremendous pressure for the past 3 years. Yet Icahn chose to double his stake in the EQUITY, while NOTbuying the BONDS.

If Icahn had any concerns about bankruptcy he would quite obviously be moving up the cap structure away from the common stock and into the bonds. A search of bond holders on Bloomberg shows that Icahn is not a bond holder.

In 2015 (after Icahn had already begun investing in Hertz), Icahn quickly invested $100 million into the ride hailing service Lyft.  Icahn chose to take down fully 2/3 of that $150 million financing round in Lyft.

The fact that Icahn chose to invest in privately held Lyft was quite notable. The New York Times observed of Icahn’s investment in Lyft that:

More surprising is Mr. Icahn’s involvement…Mr. Icahn rarely invests in closely held start-ups

Icahn demonstrated that he understands the new ride share dynamic completely.

In an interview with the New York Times, Icahn specifically said of his Lyft investment that:

What I’m saying is there is a secular change going on with the way people are getting around, and with urbanization, it means more people living in urban areas.

So as Icahn continues to ramp up his stake in Hertz, he is certainly NOT doing so because he is oblivious to the emerging dominance of ride hailing platforms. In fact, Icahn is investing in Hertz as a way to benefit from the rise of ride hailing platforms such as Uber and Lyft !

Shortly after Icahn invested in Lyft, Hertz and Lyft began teaming up, creating the above mentioned Express Drive program where Lyft pays to Hertz the cost for drivers to rent cars from Hertz rather than use their own cars. Hertz later began a program for renting to Uber drivers.

Just two months ago (June 2017), Icahn acquired car-service chain Precision Auto. That deal added 250 locations to Icahn’s existing network of 1,000 car servicing shops.

Fox Business noted that:

Carl Icahn is raising his bet that Americans won’t fix their own cars, and that eventually many might not even own one.

And then just after that, Icahn announced that he was acquiring additional THOUSANDS of auto repair shops across the country.

Jun 4, 2017 – NY Post – Carl Icahn plans to acquire thousands of auto-repair shops

In fact, over the past 3 years, Icahn has been paying top dollar across the board to assemble together an interlocking network of automotive companies which will provide rental, ride share, parts, servicing and fleet management.

Pep Boys – Icahn acquired up 130% for over $1 billion

In early 2015, auto parts chain Pep Boys was trading at $8.00.  The company was highly leveraged, heavily shorted and financially shaky. (It was quite similar in these respects to Hertz in 2017).

In December 2015, Icahn announced that he had acquired a 12% stake in Pep Boys. Just days later he made a bid for the entire company at $15.50 per share (up nearly 100%).  A bidding war ensued with Icahn bidding against Japan tire company Bridgestone.  Icahn was more than willing to outbid Bridgestone at $18.50 per share, valuing the company at over $1 billion (up 130% from just a few months earlier).  On a standalone basis, most outside observers agreed (at the time) that Icahn significantly overpaid for Pep Boys.

Here was the run-up in the stock leading into the eventual buyout by Icahn.

It took a few months, but finally the media took a completely different view of Icahn’s purchase of Pep Boys.

Why Carl Icahn’s Pep Boys Purchase Is Brilliant

***   4.  MASSIVE LEVERAGE AND COLOSSAL SHORT INTEREST WILL PROPEL HERTZ STOCK HIGHER AS THESIS SUDDENLY TURNS BULLISH

In 1H 2017, we saw shares of Restoration Hardware and Weight Watchers triple and quadruple from their lows to their highs.  Both stocks were highly levered, heavily shorted and faced very visible challenges in terms of business prospects and valuation.  In other words, in January 2017, each of Restoration Hardware and Weight Watchers was very similar to where Hertz is today.

For each of Restoration Hardware and Weight Watchers, all it took was a very MEDIOCRE re-rating of their business prospects to see them triple and quadruple in just a few months.

The meteoric rises of Restoration Hardware and Weight Watchers took everyone (especially short sellers) by complete surprise.

The reason for these wildly disproportionate share price spikes lies in the leverage and the short interest.

High leverage cuts both ways. It amplifies share price moves on the upside as well as the downside.  When a mediocre re-rating of the business causes the enterprise value to rise by even just a moderate amount, the high leverage means that the equity value vaults higher by multiples.  That is why we call it “leverage”.

Based on the information above, Hertz is due for a truly transformational re-rating of its business prospects.  While it was recently dismissed as a dinosaur business on its way to extinction, it is now being viewed as an absolutely critical component of the future of transportation.  This certainly merits a more-than-mediocre rise in enterprise value.

Hertz has a total of $16.8 billion in debt. But of this, $11.2 billion is debt secured by vehicles.  The debt that really matters to us is the $5.6 billion of non-vehicle debt.

As of June 30th, 2017 (from the Q2 Form 10Q):

Against this, Hertz’s current market cap is just $1.2 billion, giving Hertz an enterprise value of $6.1 billion

What this means is that as investors re-rate Hertz business prospects, a mere 25% rise in enterprise value translates to a 127% rise in the share price to around $32.  If investors decide that the new paradigm makes the business (enterprise value) worth double what the dinosaur was worth, then the share price should go up by 510% to $87.

Clearly this is why Icahn is completely unperturbed showing a tiny little paper loss of just $1 billion .

Against these tremendous upside prospects, it is now the case that there are more shares short than there are available shares to cover in the effective float.

As the share price has fallen lower and lower, more and more bears have piled on at the bottom. The result is that short interest now stands at 33 million shares, which is 62.0% of the stated float (according to Bloomberg).

 

 

But it actually gets worse than that. Much worse !

The already staggering 62.0% is the number reported by Bloomberg. But in reality, this number ignores the fact that several funds have initiated, maintained or increased their 5%+ positions and are unlikely to sell in the near term.  As a result, these shares are unavailable when shorts are looking for shares to cover.

Furthermore, index funds which own around 18% of Hertz are also unable to sell simply because the share price spikes. They must continue to hold in proportion to their benchmark index weights, regardless of where the share price goes.

As a result, the effective float at Hertz is around 22.3 million shares vs. the short interest which now sits at 33 million shares. There are simply not enough readily available shares for shorts to cover.

Here is the math behind the effective float.

 

(For a further discussion of the effective float, read my recent article on infinity squeezes.)

Icahn owns 35% of Hertz, which is already being factored in by Bloomberg.

Key funds which each own 5% or more of Hertz include:

  • GAMCO. Recently increased its stake by 765,100 shares to a total position of 6.6 million shares.
  • Par Capital. Just initiated a position of 5.9 million shares.
  • Glenview. Maintained a position of 4.4 million shares.

In total, these 3 funds own 16. 8 million shares that are not being sold, reducing the effective float, making it more difficult for shorts to cover. 

Index funds include Vanguard, Blackrock Dimensional and multiple others.  In total, index funds own 14.7 million shares. Because they cannot readily sell, they further reduce the effective float, also making it more difficult to cover.

Once we exclude the additional long term funds and index funds, there are only 22.3 million shares in the effective float which is well short of the 33.4 million shares which shorts need to cover.

Here is the HDS screenshot from Bloomberg.

***   5. ICAHN’S PLAY ON HERTZ VS. ICAHN’S PLAY ON HERBALIFE

Icahn’s play on Hertz is nearly identical to the play that Icahn is making on Herbalife (HLF), in which he is currently showing a profit of over half a billon dollars.

Following significant negative exposure, Herbalife’s short interest spiked, even as the share price briefly plunged below $30.

After multiple purchases starting from around $40, Icahn then began seeking permission for larger and larger stakes.  In July 2016, Herbalife agreed to allow Icahn to go up to 34.99%. And then in October 2016, Icahn received approval from the FTC to take his stake up to 50%.  In February of 2017, as the float was getting tighter and the stock was rising higher, Herbalife announced that it had authorized a share buyback of up to $1.5 billion.

As it applies to Hertz, it is very clear that Icahn is well aware of the short vs. effective float dynamic. And as we saw in Herbalife, he is more than happy to use it to his advantage.

Hertz currently appears quite levered, which has been of concern to investors.  But remember that most of that is “vehicle debt” which is secured by the vehicles.

Based on Icahn’s playbook with Herbalife, Icahn could conceivably buy more Hertz stock or use his meaningful presence on the board to encourage the company to authorize additional large share repurchase programs.

Looking back to Hertz…

In June 2016, Hertz announced a new share buyback authorization of $395 million. And then in November 2016, Icahn acquired over 16 million shares of Hertz at an average price of $23.79 for a total cost of over $388 million. This increased his total stake to over 29 million shares (i.e., 126% increase in his holdings).

Disclosure: I am/we are long HTZ.

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 is long HTZ. The author made make additional trades in the next 72 hours.

LONG $DDS Long Dillard’s on potential “infinity squeeze”

Summary

  • Dillard’s appears set up for “infinity squeeze” like VW in 2008, which sent stock up 5x. Einhorn was short VW in 2008, but is now largest outside holder of DDS.
  • Bloomberg shows short interest at 69.9% of float. But it’s worse. Index funds can’t sell. Einhorn won’t. Short interest now over 100% of effective float.
  • Aggressive share buybacks (ever after Q1) further reducing float without being noticed. Extent of any further buybacks will be announced in 2 weeks.
  • Excluding Einhorn and index funds, as few as 4.38million shares in effective float vs. 9 million shares short. I expect further Q2 buybacks of 1-2 million shares.
  • The math: shorts have now sold millions more shares than they can readily buy back from obvious sellers. Einhorn (or different 3rd party) could recall borrow and trigger massive squeeze immediately.

This article is the opinion of the author.  The author is long DDS.

Note: In general I try to link to free data sources so that all readers can evaluate for themselves without data subscriptions. But this article is very numbers-driven, so I have mostly used Bloomberg data. I have included screenshots to show the data where practicable. Other links can be clicked on from various sources, including Edgar.  In making my investment decision, I have done my own math and made my own decision.  Do your own math and make your own decision.

***   Key Statistics

Company:                 Dillard’s Inc. (DDS)

Market cap:              $2 billion

Debt:                         $820 million

Cash flow:                 ≈ $400 million per year free cash flow

Book value:               $1.7 billion (at cost, decades old prices)

Real estate:               $3-4 billion (est. current market value)

Shares short:            9 million shares (69.9% of stated float)

Free float:                 12.88 million shares

Effective float:          ≈ 4 million shares (excl. key holders / index funds)

Buyback:                   3 million YTD. Plus 1-2 million more by Aug 10th.

This trade is about the potential for a massive short squeeze due to a mathematical imbalance.  Shorts have sold millions more shares than are readily available for them to buy back.  Someone (the last to cover) will be stuck paying an astronomical price.

I am less focused on the fundamentals at Dillard’s. But it is important to at least differentiate Dillard’s from the financially shaky players like Sears (SHLD) or JC Penny (JCP).

The short thesis is simple.  Online shopping from places like Amazon (AMZN) is replacing “brick and mortar” shopping at places like Wal Mart (WMT).

But unlike many of the other department stores, Dillard’s has strong free cash flow and little debt.  Dillard’s is trading at just over book value. However, book value only values assets at historical cost, which is decades out of date.  Market value of Dillard’s real estate has been estimated at $3-4 billion.  Even with a generous haircut to those numbers, Dillard’s is still trading at a discount to its real estate value. There is effectively zero visible bankruptcy risk for Dillard’s and significant incentive for the company to go private.

Again, I am not really focused on the fundamentals at Dillard’s. This thesis is about the math that says there are millions more shares short than are in the effective float.

In any event, the numbers above arguably make Dillard’s a better long pick than Macy’s (M), Target (TGT) or Kohl’s (KSS).

But again, this is not a thesis about the fundamentals at Dillard’s. It is a mathematical trade based on the short interest exceeding the effective float.

Below we will see how the short interest somehow became the highest in the retail space. 

***   Investment thesis – set up for “Infinity Squeeze”

For those in a rush, I briefly summarize my thesis here.  In the section that follows, I include Bloomberg screenshots and additional links to SEC filings so that readers can do their own math.

Dillard’s now appears perfectly set up for an “infinity squeeze” which could be triggered at any time.

The most famous example of an infinity squeeze was that of Volkswagen AG in 2008.  When Porsche suddenly upped its stake without prior notice, shares of VW quickly rose by a stunning 5x (more than 400%) within days, making it (briefly) the world’s most valuable company by market cap at €300 billion.  Hedge funds suffered estimated losses of as much as €30 billion that week, while Porsche reportedly made a profit of €6 billion.

Clearly size is not a limiting factor with infinity squeezes.  (That’s why they are called infinity squeezes….)

As we saw with the VW squeeze, the only thing that matters in an infinity squeeze is when shorts have sold more shares than they can readily buy back in the effective float.  

At Dillard’s, short interest stood at just 20% in January 2017.  No big deal. But then several things happened.

During 1H 2017, shares sold short rose to 9 million shares. At the same time, accelerated share buybacks by Dillard’s simultaneously reduced the float to just 12.88 million shares.  As a result, Bloomberg now reports that short interest has suddenly risen to 69.9% of float. It seems that this “double whammy” of rising short against falling float had escaped the attention of short sellers who should have been paying attention. (Note that many other financial sites have also missed the buybacks. Their numbers for shares outstanding and float at Dillard’s are inaccurate and have not been updated since the 10K was filed. This is another reason why some investors are only now figuring out what has happened.)

Oh but it gets much, MUCH worse than that.

The third leg of this “triple whammy” is this:

Of the 12.88 million share float, as much as 6 million shares are in the hands of index funds (including Blackrock, Vanguard and others) who are typically unable to sell in meaningful size, even when the share price rises sharply. They must generally hold in proportion to their benchmark indices.  As I will show below, the inability of index funds to sell their shares was a key contributor to that massive infinity squeeze of Volkswagen in 2008. 

A further 2.5 million shares are held by David Einhorn’s Greenlight Capital, amounting to 9.99% of the company. As it so happens, Einhorn was on the painful side of that VW squeeze in 2008. So he can certainly appreciate the short vs. float dynamic that is suddenly unfolding at Dillard’s. (In other words, even if the stock spikes by more than 50-100%, don’t be surprised if Einhorn still isn’t selling.)

With index funds largely unable to sell much of their up to 6 million shares and with Einhorn unlikely to sell his 2.5 million shares, the true “effective float” is really as low as 4.38 million shares of readily and likely available shares for shorts to cover their 9 million shares short.

Wow. That’s really, REALLY bad.  But wait, there’s more.

In fact, to the extent that Einhorn has been lending out his shares, he could presumably recall those shares at will. This could force shorts to buy up to 2.5 million shares regardless of price – IMMEDIATELY.  And just when shorts are forced to scramble to buy shares, there are simply not enough shares in the effective float to facilitate easy covering. Anyone who is long could simply hold out for astronomical prices and the shorts would be forced to pay. This is what happened with VW and was why Porsche made a €6 billion profit in a single week.

Alternatively, the effective float at Dillard’s is now so tiny that any 3rd party investor could swoop in, buy a block of stock and recall the underlying borrow.  Given how tiny the effective float has become, such a strategy would NOT require a huge outlay of capital.  Any takers ?

This is just what “Pharma Bro” Martin Shkreli did with KaloBios  (KBIO) in 2015, causing those shares to rise by 100x (yes, 10,000%) from their lows to a high of over $44.  As a reminder, if a tiny 1% position rises by 100x then your entire fund goes to zero.

With both VW and KaloBios all it took was a single press release or Tweet from the 3rd party investor to spark the infinity squeeze which soared by hundreds or thousands of percent within just days.

As we will see below, prior to their gargantuan infinity squeezes, media sources reported that short interest was at less than 15% for both Volskwagen and KaloBios. By comparison, reported short interest at Dillard’s now stands at 69.9% according to Bloomberg.  This shows how vulnerable Dillard’s share price is to such a massive squeeze.

Ok. So it couldn’t possibly get any worse, right ?!  Wrong.

It is the ongoing share buybacks by Dillard’s that caused this precarious situation to develop without notice. And with the stock hovering near 5 years lows during Q2, those buybacks have recently been accelerating. A lot.

Dillard’s announced Q1 (ended April) results on May 11, 2017.  In that press release, Dillard’s announced that it had repurchased 1.7 million shares. This would leave Dillard’s with 26.49 million Class A shares outstanding as of April 29th.

But in the Form 10Q which was released 3 weeks later on June 6th, the share count on the cover page was only 25.178 million dated as of May 27th. This means that 1.3 million more shares were bought back in May (the first month of Q2, which will not be fully disclosed until August 10th).

This 25.178 million share count number was updated on Bloomberg, but it seems that few people noticed the impact that this would have on the float, especially vs. the rising short interest.  There was NOT a press release announcing the repurchase of the additional 1.3 million shares.

So during just a 3 week period, investors who had been paying attention should have realized that the float had shrunk by 3 million shares.  During this same few weeks, shares short rose by 3 million shares.

This is how we quietly got to a staggering short interest of 69.9% apparently without many people noticing.

In fact, Dillard’s has the cash and the approvals to have been conducting even more buybacks in June and July.

On August 10th, (about 2 weeks from now) Dillard’s will release Q2 results and will reveal how many shares were bought back in June and July.

As a reminder, Dillard’s generated over $400 million in free cash flow last year and has aggressively repurchased shares in each of the past 6 quarters.  These buybacks have visibly become more aggressive as the share price has fallen.  During Q2, the share price continued to hover near 5 year lows.

I expect that on or about August 10th, we will see that Dillard’s repurchased 1-2 million additional shares in June and July.

If this turns out to be this case, it would further reduce the effective float to as little as 2-3 million shares which would be likely and readily available for shorts to cover their 9 million share short position.

Here’s the rub:

The conceptual risk here is that Einhorn or any third party investor decides to recall stock borrow and force a squeeze when so few shares are readily available.

Einhorn has been gradually acquiring over several years, but his stake is still just under 10%, meaning that he his not an affiliate.  So simply deciding to stop lending shares should not be controversial in my view.  Likewise, an outsider could end up triggering a squeeze even by acquiring less than 5% of outstanding shares. This would be far less aggressive that what Shkreli did with KaloBios in 2015. Shkreli has come under tremendous scrutiny from regulators and the media for a variety of his past actions. But so far I have not found any mention of the KaloBios squeeze amongst his current regulatory problems.

Either way, even in the absence of such a trigger, I expect shorts to rush to exit their positions in Dillard’s well before the new share count is revealed on or around August 10th.  At the same time, I cannot imagine why any longer term holders would be selling prior to August 10th, when the extent of share repurchases is revealed.

***   The math – potential infinity squeeze at Dillard’s

There are 9 million shares short at Dillard’s but there are only around 4 million shares which are likely and readily able to be bought back. 

Dillard’s Shares in the effective float
Float: 12.88 million Stated float as per Bloomberg
less:    6.0 million Shares held by index funds (cannot readily sell significantly)
less:    2.5 million Shares held by Greenlight Capital (very unlikely to sell)
Total:  4.38 million Effective float = shares readily and likely to be buyable

(Potential for further float reduction of 1-2 million shares due to possible buy backs in June-July could leave as few as roughly 2-3 million shares in the “effective float”. Q2 results and buyback size to be released on or around August 10th.)

At Dillard’s there are 25 million shares outstanding.  But 12.297 million shares are “stagnant” in the hands of various insiders (including Dillard family members) and Evercore (which manages the Dillard’s 401K plan).

This leaves only 12.88 million in the public float, as per Bloomberg.

Also as per Bloomberg, there are currently 9.0 million shares short in Dillard’s, which already amounts to 69.9% of this stated float.   Number of shares short is up from 3.6 million in January 2017.

Below is the list of holders of Dillard’s stock from Bloomberg.  As I see it, the obvious index funds include Blackrock and Vanguard. Dimensional also takes a hybrid index approach.  Even funds such as BNY Mellon and State Street have funds that allocate via indexing.  Collectively index funds own as much as 6 million shares. A screenshot of the Bloomberg HDS table is also included below.

Note that as of the last reporting dates, 18 out of 20 of these holders INCREASED their positions in Dillard’s as shown on Bloomberg.

But also note that because some of these holdings are reported as of March and some as of June, we there will be some overlap in the holdings across these periods. This will obviously change over time.

As you can see from the HDS table from Bloomberg, Einhorn’s Greenlight Capital increased its stake in Dillard’s by a net 623,675 shares in the past quarter.

(Note: SEC filings show that Greenlight did sell a mere 35,125 shares in June so as to keeps its stake at just under 10% of Dillard’s. When Dillard’s Form 10Qrevealed in June that the share count had shrunk by 1.3 million shares in May, it resulted in Greenlight’s stake briefly exceeding 10%.  Greenlight’s tiny sale occurred immediately after that disclosure and took their stake back down to 9.99%.  Note that Einhorn’s stake did INCREASE by a net 623,675 shares in 1H 2017.)

The reason I assume that index funds cannot for the most part sell meaningful amounts of stock at will is partly just common sense.  They are index funds. But also, we saw in the 2008 infinity squeeze of VW, it was the inability of index funds to sell their shares that contributed to the height of that squeeze that saw the shares rise by 5x within just days.

We know this because as the squeeze was in full effect, German officials quickly stepped in and conducted an emergency de-weighting of VW within the DAX index, allowing these index funds to sell.

From the New York Times on October 30th, 2008:

By Tuesday night, the establishment was fighting back. Germany’s premier stock index, the DAX, was changed to cut VW’s proportion in it. That allowed index funds to sell stock, adding to the supply of shares, and VW’s shares lost part of their gains.

Greenlight’s average cost basis on Dillard’s is listed on Bloomberg at  $78.47. And they have been increasing the position in recent periods. Knowing that, in combination with Einhorn’s experience in VW, I do not expect David Einhorn to be selling just to alleviate an obvious short squeeze (unless we see the share price at much, much higher levels).

After all…why would he ?

So if we decide that index funds either can’t or won’t sell in meaningful size and that Einhorn is also unlikely to sell, there are really as few as 4.38 million shares readily available and likely to be sold for shorts to cover their 9 million shares short.

Next let’s look at the share buybacks by Dillard’s which are rapidly shrinking the float.

Dillard’s has been aggressively buying back stock for (at least) the past 6 quarters in a row.

As shown, in the past 6 quarters, Dillard’s bought back shares as follows:

Date (EoQ) Value repurchased Shares repurchased
1/30/2016 $117.5 million 1.6 million
4/30/2016 $58.4 million 0.7 million
7/30/2016 $54.1 million 0.9 million
10/29/2016 $53.1 million 0.9 million
01/28/2017 $80.6 million 1.3 million
04/29/2017 $91.1 million 1.7 million

NOTICE how those buybacks have been getting more aggressive each quarter as the share price was falling.

Also NOTICE that the share price during Q2 continued to hover near 5 year lows. This is why I expect that another 1-2 million shares were repurchased in June-July.

These ongoing buybacks (and the reductions in share count / float) were a major contributor to the short interest rising from 20% in January to 69.9% at present.

Just from May through June, short interest rose from around 40% to 69.9%.

Just look at the steep trajectory of the short interest vs. float in the chart below, which took off in January and then accelerated from May through June.

When Dillard’s announced Q1 results (ended April), they also announced that the company had bought back 1.7 million shares in that Q1.

But many people failed to notice that by the time the Form 10Q was actually released in June (3 weeks later), that the share count had fallen by an ADDITIONAL 1.3 million shares, even AFTER Q1 had been fully reported.

In other words, just in the month of May, Dillard’s accelerated its buyback, buying 1.3 million shares in a single month, reducing the Class A share count to just 25.178 million.

Realize that there was no paragraph in the 10Q explicitly spelling out further buybacks during May. It was just a change on the cover page to the number of shares outstanding.  That change was quickly reflected on Bloomberg but it seems many people either missed the change or failed to appreciate its significance.

Here is a screenshot from the cover page of the Form 10Q released in June 2017.

(Note: Dillard’s has 4.01 million shares of Class B stock which gives Dillard family members voting control of the company. The Class B shares do not trade. The number of Class B shares outstanding and the ownership by the family members has remained constant going back to at least 2008. The Class B shares have nothing to do with the tradeable float or short interest.)

With the stock price hovering mostly near 5 year lows for much of June and July, I feel that it is safe to assume that across June and July, Dillard’s likely bought back an additional 1-2 million shares, further reducing the effective float.  They certainly have the cash flow to do just that.

Further repurchases would also be consistent with their behavior over the past 6 consecutive quarters.

Here is the annual free cash flow for Dillard’s over the past few years.  Notice that for the year ended January 2017, Dillard’s generated over $400 million in free cash flow.

Date (FY) Free Cash Flow
1/28/2012 $385.5 million
02/02/2013 $386.1 million
02/01/2014 $406.8 million
01/31/2015 $459.7 million
01/30/2016 $284.4 million
01/28/2017 $412.2 million

And remember that Dillard’s ended the April Q1 with over $300 million in cash.

In fact, we can see that this pattern of aggressive share buybacks has been going on for years.  Ten years ago, Dillard’s had roughly 60 million shares in the float. That has since fallen by nearly 80% to 12.88 million.

So given the chart above, choose which of the following scenarios would surprise you more:

Scenario A.  After more than 10 years of aggressively buying back billions of dollars worth of its own shares, Dillard’s finally acquired all shares and took the company private when the stock was near 5 year lows.

Or…

Scenario B.   After more than 10 years of aggressively buying back billions of dollars worth of its own shares, Dillard’s suddenly stopped buying when the stock was near 5 year lows.

You can decide for yourself.  But while you’re thinking about it, also consider this.

Whatever Dillard’s is theoretically “worth” as an entity, that value is increasing sharply on a per share basis as a result of those buybacks.

Some investors may look at “free cash flow per share” others may want to look at “book value per share” to approximate the estimated $3-4 billions of dollars in real estate that Dillard’s owns.  Either way, on a per share basis, any per share number is increasing sharply due to the buybacks.

Obviously reported “book value” will be very out of date because it only reflects the cost at the time the real estate was acquired in past decades.  The market value of the real estate should certainly be much higher than book value. But just to get an idea of the impact of the buybacks on book value per shares, here is the chart from Bloomberg.

Anyone who is short Dillard’s need to factor this rising value per share into their target prices.

Here is one presentation that valued Dillard’s real estate at as much as $6 billion.  I am not really trying to take a guess at that number.  Instead, I am satisfied that even with a substantial haircut to that number, the current value of Dillard’s real estate ALONE is still well above Dillard’s market cap. (And that ignores the ≈$400 million in free cash flow.)

***  What could actually spark an infinity squeeze at Dillard’s  (like, as in RIGHT NOW) ?

Just prior to the 2008 infinity squeeze on VW, short interest at VW had been reported at just 12.9% of outstanding, which did not seem alarming.  For Dillard’s, the reported short interest on Bloomberg was only 20% in January, but it has already risen to 69.9% as of now. That is absolutely alarming.

In the Volkswagen squeeze of 2008, the trigger was when Porsche AG suddenly increased its stake without notice.

Remember that Einhorn was on the painful side of the 2008 infinity squeeze on Volkswagen. Shortly after the VW squeeze, Einhorn’s subsequent investor letter revealed some valuable lessons for those caught in such a squeeze on how they can live to fight another day rather than going down with the ship.

Here is a screen shot from that investor letter which discusses how Greenlight handled the infinity squeeze on Volkswagen (“VOW”).

I strongly suggest that anyone who is currently short Dillard’s read that quote from above.  And then go back and read it again.

Focus on this part:

The worst trade is the one you don’t want to make, but the one you have to make…..we are unwilling to risk the entire portfolio on a single investment….Though VOW was not a large position on Friday, it became one by Tuesday.

The now-tiny effective float means that even aside from Einhorn there is now a very real possibility that a different 3rd party could swoop in and ignite a similar squeeze by simply buying a small chunk (less than 5%) of the stock and then recalling the borrow underneath it. Such a strategy would NOT require a huge outlay of capital.

This is exactly what Martin Shkreli did in 2015 when he bought shares of KaloBios and recalled the borrow.  Shares of KBIO quickly skyrocketed by 100x (yes, nearly 10,000%) from their lows.

The table below shows the 100x rise in KaloBios’ share price following the announcement of  Shkreli’s purchase on November 18th.

Note carefully that the share price had been rising sharply in the days leading up to that announcement.  And that KaloBios’ share price quickly soared by 10,000% to a high of more than $44.

LOOK at the dates. and then LOOK at what the prices did in percentage terms.  When these squeezes happen, they are sparked immediately overnight and then continue squeezing for many days.

This is what Einhorn meant about “unwilling to risk the entire portfolio on a single investment” and “not a large position on Friday, it became one by Tuesday”.

As you can see above, the squeeze unfolded over multiple days as certain investors tried to “wait it out”, thinking that the stock would have to come back down once the “weak shorts” were flushed out.  It turns out that the ones who covered early were actually the ones who made it out with the least damage from this 10,000% rise in just 7 days.

The infinity squeeze on KaloBios was made more memorable by retail trader Joe Campbell who started a GoFundMe account to seeking contributions after his $37,000 account lost nearly 400% of its value overnight, leaving him over $100,000 in debt to Etrade. Campbell had been short the stock at around $2.00 at the close on November 18th, prior to the announcement on Shkreli’s purchase.

Trader Begs for Help to Pay E-Trade $106,000 After Biotech Blow-Up

But Shkreli wasn’t content with the rise from $2.00 to the $20s.  He wanted more. And any time we see a mathematical imbalance of shares short vs. effective float, this goal becomes very easy to obtain.

On Thanksgiving day, Shkreli put out the following tweets, sending the stock as high as $45 (up another 73% in a day) when markets reopened on Friday.  KaloBios’ stock had been at just 44 cents 10 days earlier.

Notably, short interest at KaloBios just prior to the squeeze had been reported at less than 10%. Obviously this is far lower than the 69.9% we see reported at Dillard’s.

Regardless of what anyone thinks about Dillard’s current share price, it is hard to deny the fact that the stock is now extremely vulnerable to a potential squeeze play by an outside investor, similar to what Shkreli did with KaloBios.

So again, here is the math as I see it with Dillard’s: 

There are as few as 4.38 million shares which are readily able and likely to be sold by existing holders.  But there are 9 million shares short which need to be bought.  This situation is already very bad, but it could get dramatically worse in just an instant in a single day if anyone chooses to recall borrow or acquire any meaningful new stake.

I expect this aleady-bad situation to get much worse on August 10th when we learn just how many shares Dillard’s bought back in June and July.

Again, I am expecting to see additional repurchases of up to 1-2 million shares, which would reduce the effective float to as low as roughly 2-3 million shares even as the number of shares short sits at 9 million which must be covered.

Given the cash flow, the real estate and the aggressive buybacks at Dillard’s, a short bet on the stock was already not a particularly bright one in the first place.  But given the rate at which the float is disappearing and the potential for an ignited infinity squeeze, staying short Dillard’s now is just plain lunacy. 

Do your own math. Conduct your own analysis.  Make your own decision.

***   The shorts aren’t dumb – so how did we get here ?

Here is the way I see it.

A major contributor to this infinity squeeze setup is just the fact that Dillard’s does not appear to be a “conviction short” for anyone. As far as I see, no one is shorting Dillard’s simply because of a view on Dillard’s. Instead, there are many funds taking small positions of 50-100 bps in each of multiple department stores as part of a vey generic sector short on retail.

As recently as January, the short interest in Dillard’s still sat below 20%. It wasn’t really that bad.   Yes, the number of shares short at Dillard’s steadily increased. But so did the number of shares short for most department stores. Hedge funds were just spreading their bets around.

With Dillard’s, there has been a “triple whammy” which caused a sharp change in the short interest relative to the effective float changed. The sharp change happened fairly quickly without anyone noticing until it was too late.

Here again is the triple whammy.

The float was already quite low at Dillard’s.  This meant that the stock buybacks by Dillard’s had a disproportionate impact on the remaining float. As the float continued to shrink, the significance of the position held by Einhorn and the index funds grew quickly and exponentially.  But because Dillard’s was just part of a larger generic sector short for hedge funds, this dynamic was missed by those who were going short. For most investors, their short positions were just too small to merit significant individual attention.  Since January 2017, hedge funds steadily increased their short bets against a wide variety of department stores. But with Dillard’s specifically, they were increasing a short bet against a disappearing float and against an effective float that was shrinking even faster (due to the impact of the buybacks).

And now there there are millions more shares short than are in the effective float which can readily be bought back.

Disclosure: I am/we are long DDS.

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: This article is the opinion of the author. The author is long DDS. The author may make subsequent trades in various securities mentioned in this article within the next 72 hours.

$ARA American Renal: JV partners rushing to sell equity stakes. But why ?

Summary

  • ARA’s JV partners are suddenly exercising their put options nearly as fast as they vest, requiring ARA to buy out their equity stakes. The reasons are becoming clear.
  • Post Q1 news: insurers now rejecting charitable assist on BOTH ACA AND non-ACA plans. Fraud lawsuit against ARA spurred federal investigations into “charities”, now from three separate federal agencies.
  • Hypersensitivity of ARA to several very small variables such as put exercises and commercial mix. Tiny changes are suddenly wreaking havoc on ARA.
  • ARA is merely an “also covered” stock. Analysts only focused on much larger competitors DVA and FMS, and have completely missed problems at much smaller ARA, which are very unique and very deep.
  • Base case decline of 60% to $7.  But with $500 million debt + $132 million put liability, also a strong case for later insolvency (ala Adeptus).

 

The information below represents the opinion of the author.  The author is short ARA.

Company snapshot

Name:           American Renal Associates (ARA)

Business:      Dialysis provider

Share price:  $17.36

Market cap:   ≈$550 million

Debt:             ≈$500 million plus $132 million in put liabilities to JV doctors

Borrow:        At least400-600k shares (up to $10 million)

Borrow fee:  0.90%

Options:       Calls and puts

Overview

Right now shares of American Renal Associates (ARA) are trading for around $17.  If things go “better” than expected, then I expect that the shares may “only” fall to around $7 (down 60%).

But in reality, a more likely scenario in the foreseeable future is actual insolvency for this troubled dialysis provider.  If that view sounds extreme to you, then just read on. I think you will see clearly what I mean below.

As I will repeat throughout this article: Do not believe me. Do not believe the sell side.  Instead, look to ARA’s JV partners (insiders) who are now exercising their put options nearly as fast as they can possibly vest them.

Below I will spell out clearly:

  • why things are so bad for ARA
  • why they are much, MUCH worse for ARA than at DaVita  (DVA)
  • how we KNOW with certainty that things are so bad at ARA
  • how we know things are unraveling NOW
  • WHY analysts and investors have missed all of this at ARA

In the past, my articles on multiple private equity backed IPO’s ended up quickly presaging declines of 70-100% for stocks like IRG and Erickson Air Crane (among others).   With Erickson, the stock fell as much as 30% on the day of my article. But the pain was actually just beginning. The stock went on to be a true zero and quickly ended in bankruptcy.

My articleMassive Insider Deal Threatens Erickson Air-Crane

Later news:  Mystery silence at Erickson Inc. ends with bankruptcy filing

But as I will show towards the end of this article, an even better template for ARA is the bankruptcy and implosion of Adeptus Health (ADPTQ).

** Parallels between ARA and Adeptus too obvious to ignore **  

Here are just nine obvious ways in which ARA looks like an identical replay of bankrupt Adeptus which quickly fell from $120 down to $1. 

Just to make things simple, I will number the most obvious similarities.

Adeptus was 1) a private equity backed 2) healthcare services IPO which 3) surged after it came public only to see 4) its results falter amid 5) overpayment issues which were 6) exposed in news reports over its 7) problematic business model. 8) Despite the emergence of obvious problems, the sell side banks were more than eager to hype the stock (and at Adeptus were then more than willing to accept the banking fees from the huge share sales by Adeptus’ private equity backer).  9) Numerous hedge funds naïvely piled into the stock.  Just like ARA, Adeptus’ public problems began with a simple newscast revealing the problems with overcharging. Even until the bitter end, and despite the increasingly obvious problems, analysts were telling investors that Adeptus was a “buy buy buy”.

Adeptus soon filed for bankruptcy and the stock now trades for around $1.00 with the dreaded “Q” added to its ticker.  Down more than 99%.

From FT.com:  Rise and fall of Adeptus is perfect parable of Wall St hype

** A detailed look at American Renal **

The key to understanding the short thesis on ARA is understanding why the nephrologists (ARA’s joint venture partners) are suddenly rushing to exercise their put options on the business, requiring ARA to buy them out of predetermined equity stakes.

As part of the JV structure, ARA grants to the clinic operators (nephrologists) put options allowing them to force ARA to repurchase a predetermined portion of their equity stakes.  The total size of this put liability for ARA is currently $132 million, however most of these options are not currently vested or able to be exercised.  There are a total of $36 million of “event based” puts which are not exercisable until  the occurrence of certain future events. The other $94 million of these puts are “time-based” put options which become only exercisable after certain specified dates. For example, over full year 2017, $23 million of these time based puts will become exercisable by the end of the full year.

These nephrologist partners are the ones who actually operate the dialysis clinics on the ground, such that they understand the business better than anyone.

Better than ARA, better than investors, better than sell side analysts.

In fact, these JV partners have now suddenly begun exercising these puts and selling their equity in ARA nearly as fast as they can, cashing out as much as 50-80% of all vested time-based put options in a given quarter.  This is a very recent and sudden development and is unprecedented in the history of ARA.  As new troubles have begun to hit ARA.

These JV partners recently exercised more puts in a single quarter than had been exercised in the entire cumulative history of ARA.

But in conveying their optimism for ARA, sell side analysts have completely ignored this surge of JV partners suddenly cashing out as fast as they can.

What investors need to see is this:  not all of the put options are currently vested. Only a small portion can currently be exercised.  Of that small portion where they actually CAN exercise, the JV partners ARE exercising nearly everything they can as fast as they can. 

In other words, it is not the SIZE of the total exercises, but rather it is the RATEthat these puts are being exercised as soon as they vest.

So the question is WHY are these JV partners rushing to cash out as fast as they can ?

My short answer to “why” doctors are cashing out is this:  Following the slow unraveling of the “charitable assist” model towards Medicaid patients in 2016 and the ongoing “patient steering” fraud lawsuit, ARA’s commercial revenue mix is falling much faster than expected. This is important because commercial payors have historically reimbursed at roughly 4x the rate of Medicare/Medicaid (or even more). The JV partners can clearly see this sea change in reimbursement on the ground, in complete contrast to the continued “hopes” expressed by  analysts. In addition, ARA’s commercial mix has historically been elevated to a much higher level than competitors such as DaVita.  As the practice of “premium assist” continues to come under ever greater pressure, ARA has much further to fall than DaVita.  Because more than 100% of ARA’s profits / EBITDA come from just the 14% of commercial mix, ARA is truly hyper sensitive to even a tiny drop in the commercial mix. ARA’s remaining 86% of revenues are deeply unprofitable.  On a recent conference call, ARA quietly mentioned that going forward it would only be disclosing commercial mix on an annual (not quarterly) basis.  Investors will therefore now have a 1 year lag behind what the JV partners know regarding the commercial mix.  Furthermore, compared to DaVita, ARA is heavily and uniquely over-exposed to the JV/Put model, such that individual doctors will end up competing with one another to be the first to get their money out of heavily indebted ARA. So this is why the doctor / JV partners have been rushing to exercise their puts as fast as they can. More details below.

 

** The big question for investors **

As we will see below, the overall size of the put liability and exercises is NOTcurrently enough to sink ARA by itself.  Instead, the sudden and rapid exercise of the puts by the JV partners is just signal of what these on the ground participants know that the rest of us do not.

The biggest question investors should ask themselves is this:  If ARA’s JV partners are rushing to SELL their puttable equity stakes nearly as fast as they can, then who on Earth would be foolish enough to BUY ARA stock at the same time ?!?!

As investors start to figure this out, this is why I expect significant near term downside to the stock.  Simply no one should be foolish enough to step up and buy ARA at anywhere near current prices.

** JV put exercises – how sudden ?  how steep ? **

Looking more closely at this surge in put exercises, as of ARA’s IPO prospectus in April 2016, the company disclosed that:

Since our inception, only $5.8 million of time-based puts have been exercised by our nephrologist partners.

(Note that this equates to just $0.96 million per year since inception.)

Then starting at the beginning of 2H 2016, ARA was hit by a wave of negative articles from the New York Times along with a fraud lawsuit by United Health describing “fraud” and “patient steering”. The fraud lawsuit was then followed by even more negative actions in August from the Department of Health and Human Services which explicitly sought to curtail such “steering”.

By September of 2016 (immediately after these problems became public), we saw that the nephrologist partners very suddenly began exercising their put options almost as fast as they could even vest them.  Anyone watching this should have viewed is as a very drastic about-face vs. the prior 6 year history of ARA. It was unprecedented.

As of Q1, these nephrologists have already exercised more than $12 million of these puts just since Q3. This more than double what had been exercised in the entire prior 6 year cumulative history of the entire company !

The point is this: on the surface $12 million doesn’t sound like a massive number by itself.  And this is why analysts and investors have ignored the significance of it.

But more important than the SIZE of the liability is actually the RATE at which these doctors are exercising their puts. Not all of the equity is actually subject to put provisions.  The point is this: for the portion which IS subject to put provisions, doctors are now exercising as much as 50-80% of all vested options in any given quarter. This has continued into Q1 more recent events now suggest that it will accelerate into Q2.

The JV partners are rushing for the exits nearly as fast as they can. The only thing slowing them down from taking out more of their money is the vesting schedule which is staggered over time.

Obviously this is a very stark contrast to what was disclosed by ARA in the IPO prospectus.

For example, as of the end of Q2 2016, only $15.5 million of these time-based options were exercisable for the entire remainder of 2016 (two more quarters). But, as shown in “purchase of non controlling interests”, the nephrologist partners immediately exercised $8.1 million in Q3 alone, immediately after the bad news began to hit (more than 50% of vested options for 2016 exercised in just a single quarter).

For all of 2017, there are only $23 million in time-based puts which become exercisable over the course of the entire year. Yet in Q1 alone, the JV partners had already exercised $4.5 million in just that first available quarter, as shown in “purchase of non controlling interests”. This is therefore on track for nearly 80% exercise of all vested options once they actually become vested over the course of 2017.

And also keep in mind that there are also an additional $36 million of “event-based” puts which are triggered by separate events and which are not part of this “time based” vesting schedule.  Once these become triggered and vested, JV partners can then start selling those equity stakes as well.

This sudden urgency to exercise vested puts tells us that the problems facing ARA are very real. And it is being conveyed to us by the local nephrologists who know the business even better than ARA itself.  (Certainly far better than analysts and investors.)

** And then there’s that $500 million in debt  **

The insolvency case for ARA is all the more likely due to the $500 million in debtthat ARA has taken on. ARA recently extended the maturities of its debt, so any insolvency is not going to happen overnight.  But the purpose of this huge levering up, of course, was largely for the simple purpose of just handing out large cash dividends to its private equity backer / shareholder.

Here is just one past headline from before the IPO

Centerbridge Partners-backed American Renal Associates is planning to pay $200m in debt-financed dividends.”

As we saw with Adeptus, once PE firms get their first payouts via debt financed dividends, I frequently see them start banging out equity offerings regardless of price.  By the time they are playing with “house money” it matters much less if they sell at $10 or $20, (or even $5). In all scenarios, life is good.

 

** Negative developments that spurred put exercise (2016- 2017) **

The first wave of negative developments for ARA began in mid 2016. By now these first wave developments have been widely disseminated and are well understood.  These developments from 2016 are not, not, NOT part of my short thesis on ARA !  But they do need to be understood for context. After that, we can look at newer (2nd wave) developments in 2017 over just the last few weeks which have been missed by the market.

Developments from 2016 included a series of scathing articles in the New York Times specifically naming ARA and a lawsuit against ARA by United Health (alleging millions of dollars in fraudulent “patient steering”).

It appears that the lawsuit filed by United Health may have been deliberately overly broad. Although the suit was filed in Florida, it included United Health Ohio as a plaintiff in addition to United Health Florida.  The suit also named an ARA holding company in Massachusetts which has no presence in Florida.

In fact, the strategy by United Health appears to have been pure genius.  Not surprisingly, the subclaims including United Health Ohio and the ARA holding company were both dropped or dismissed.  Those outcomes should have been entirely obvious in advance. The remaining fraud suit of United Health Florida vs. ARA continues to be ongoing.

The genius part is that United Health achieved a near immediate launch of multiple federal investigations into the allegations of fraudulent patient steering.

I STRONGLY encourage readers to view the entire fraud complaint by United Health against ARA. It contains a detailed explanation of the “patient steering” allegations along with a wealth of detailed numbers and data regarding Medicare, Medicaid and commercial reimbursements and other data which are otherwise very difficult to find. 

Link:  Legal complaint – United Health Vs. ARA – Fraud

The New York Times began covering the allegations of steering immediately after the lawsuit was announced. And within weeks, the US department of Health and Human Services initiated a ruling to stop the patient steering which it said had been evidenced by “social workers, health plans, patients, and other stakeholders”.

HHS Publishes a New Rule to Protect Dialysis Patients From Being “Steered” into Private Coverage for the Benefit of Dialysis Centers

In December 2016, the New York Times then published a detailed expose on the American Kidney Fund, which had been the conduit for the patient steering fraud by ARA according to the United Health suit.

NY Times: Kidney Fund Seen Insisting on Donations, Contrary to Government Deal 

The government deal cited by the New York Times refers to the promises that AKF had made in order to avoid violating federal anti-kickback laws.

In January 2017, the HHS ruling was stayed by a Texas judge (on procedural grounds only, not on its merits). Some analysts and investors then hoped that ongoing damage to the dialysis players could be mitigated.

In January 2017, federal scrutiny intensified further, into a second federal agency when the US Attorney’s Office sent out subpoenas to numerous dialysis and drug companies as part of its investigation into “charitable” premium assist. This included ARA.

Article: Dialysis Chains Receive Subpoenas Related to Premium Assistance

The subpoenas certainly have not been lost on the JV partners.  This too has been disclosed and is well known. But the surge in put exercises that followed the subpoenas into Q1 2017 has been totally ignored by analysts and investors.

** Brand new developments in past several weeks (May-Jul 2017) **

More recent developments (which came to light only AFTER Q1 was reported by ARA in May) have been either totally missed by analysts and investors or not fully understood in the context of ARA.

The first wave of developments in 2016 already led to unprecedented cash outs by ARA JA partners via their put options.  And now, recent news over just the past few days and weeks appears to be far worse for ARA.  When Q2 is announced in a few weeks, we will then be able to see the impact on ARA’s financials and additional put exercises.

These newest negative developments for ARA include newly revealed  policies by national commercial insurers to outright refuse premium assist payments from “charities” such as the American Kidney Fund (“AKF”).

For ARA, the impact of this will be a shift in patient mix, which is in fact a double whammy.  There will be a decrease in lucrative commercial patients who will be switched to money losing Medicare patients and an increase in loss making Medicare patients.  Rather than receiving around $1,000 from commercial insurers, ARA would instead receive $200-250 per treatment from Medicare.  The cost to treat patients ranges from $300-400.

Although the shift in reimbursement practices has not been widely reported, ARA’s JV partners would have seen this in practice long before anything would appear in the media.

Notice of these new insurance developments just began in May 2017 (after ARA announced Q1), but was initially limited to specialist dialysis industry journals. Until just the last few weeks, there had been no mainstream coverage that I can find, so this has not been widely known.

But in just the last few days, new headlines have begun to emerge showing that insurers in multiple states are now refusing to accept premium paymentsto insure dialysis patients who already qualify for Medicare/Medicaid and should not be on private insurance.

July 1, 2017 – South Carolina

Article: Kidney patients in SC being forced off of private insurance

June 16, 2017 – Bloomberg

Article: Healthcare investors are in denial

In addition, by looking at the following quote from DaVita to a specialist dialysis industry journal, we can see that the insurance crackdown is now a) stemming from multiple insurers and is b) affecting multiple types of policies (both ACA and non ACA).

So far, most insurers engaged in this activity are only targeting patients on individual (or ACA) plans,” DaVita said. “Recently, however, we have seen the first example of an insurance company trying to use the same tactics to push patients out of their Medigap plans.

In June 29th  (just 2 weeks ago), we then saw an escalation of the federal investigations into “premium assistance charities” reported on Bloomberg. These charities are the ones operating the model that drug makers and dialysis providers have been using to receive vastly elevated vastly commercial reimbursement.  The various investigations and actions by the federal government into this “charitable” activity have now extended into their 3rd federal agency: now including the US Attorney’s Office, the Department of Health and Human Services and (most recently) the Internal Revenue Service.  

The recent IRS case focuses on the Chronic Disease Fund, an industry funded “charity” which channels payments from drug makers to support co-pays. This model is effectively an iteration of the same model used by the American Kidney Fund, which is supported by the dialysis industry, including ARA.

In fact, all of this comes on top of new and onerous advances in state legislationin May 2017 to regulate dialysis providers, imposing mandatory staffing (labor) levels for techs and nurses in dialysis clinics.  ARA is not overly exposed in California, but just like the minimum wage hikes that started only in California, this legislation has the potential to spread more broadly to other states.

**  The future of “charitable assistance” and its impact on ARA **

After all of the drama and exposure over “patient steering” in 2016, in Q1 ARA suddenly disclosed that it had stopped “assisting” Medicaid eligible patients in securing private commercial insurance via AKF.

Following the ballooning accusations of “patient steering” fraud in 2016, the reason for this change by ARA is quite obvious.

Medicaid pays for 100% of a patient’s costs and requires virtually zero out of pocket to the patient.  When a provider such as ARA “assists” these patients into commercial insurance policies, it clearly provides zero benefit to the patient and serves only to quadruple the reimbursement to ARA (or more). This switching of Medicaid eligible patients is visibly indefensible.  And that is why ARA had to stop doing it. As a result of this factor alone, ARA’s commercial mix immediately fellby more than 2%.

But dialysis providers, including ARA, continued to assist Medicare (as opposed to Medicaid) eligible patients in getting into commercial policies.  Commercial (non Obamacare) patients accounted for 13% of revenues is 2016, but ARA recently disclosed that even this would now drop by a full percentage point in 2017.

Up until recently, industry-funded “charities” have spun a great story about how they help patients. But with three separate federal investigations / actions underway, everyone should start to realize that this “charitable” (industry funded) premium assist racket is likely going to be greatly curtailed or could even go away completely.  The mechanics of this scheme are simply becoming too transparent.

Here is how the “charity” racket has worked to date:

As I look at the IRS and other cases, “charitable” assistance allows the providers to channel small amounts of money, using certain “charities” as a “conduit”, to just pay the small premiums and co-pays for patients in order to obtain full insurance reimbursement.

Yes, this certainly appears to be giving support to poor and vulnerable patients.  And that all sounds great. These companies and the charities publicly remind us of their public service in every chance they get via press releases and public statements.

But in fact the tiny payments of premiums and copays, sourced from the providers themselves, yields tremendous profits when insurers or CMS are forced to foot the bills for their drugs or services.  After the “charity” pays these small co-pays and premiums, the massive reimbursement ultimately flows right back to the providers who made the “charitable donations” in the first place.

Got it ?!

(As an illustration: In the case of dialysis, Medicare/Medicaid only pay the clinics around $200-250 per treatment. But with private commercial insurance, these clinics can get reimbursed up to $1,000 for in network and up to $4,000 for out of network. In other words, the dialysis providers can get from 4-20x the reimbursement rate for providing the same exact services to the same exact patients. Many very poor dialysis patients can’t afford private insurance, so the American Kidney Fund pays their premiums for them.  The AKF is overwhelmingly funded directly by the dialysis providers, such as ARA, who then receive the 4-20x reimbursement.  Hence the tremendous incentive to “steer” or “assist” these patients into private insurance.)

In fact, the real beneficiaries of these “charitable” activities are actually the drug makers and dialysis providers themselves as a result of the tremendous payments they rake in from private and government payors who are on the hook for these elevated treatment costs.

But now, as we are seeing in recent weeks, the jig is up. Insurance companies and the federal government are now pushing back aggressively against this nonsense in all directions and all at the same time.

Given that many of ARA’s remaining commercial patients are still receiving premium assistance, there is still plenty of further damage to be done to ARA’s financials once these patients get transitioned to Medicare.

** Impact on ARA – why JV partners are suddenly freaking out **

Even into Q1, JV partners were rightfully exercising their puts largely as fast as they could, to get whatever money is obtainable as soon as they can. Given the new developments in May-July, I can only expect the put exercises to accelerate into Q2.

Media coverage of new problems has been building in recent weeks, but has still been relatively limited.  Although investors and analysts are still in the dark, the on the ground JV doctors have had full visibility from the clinic level. JV partners have first hand knowledge which is far greater and earlier than any media coverage.  This should become even more evident when ARA releases Q2 results in a few weeks.

Shareholders who figure this out will certainly follow the example of the nephrologist JV partners and sell sooner rather than later.

It all comes down to ARA’s hypersensitivity to commercial revenue mix.  This is what the JV doctors know far better than anyone else.

First look at this:

For Q1 of 2017, ARA’s revenue increased by 3% and the number of treatments performed increased by 10%.  That sounds good right ?

But ARA’s reported adjusted EBITDA figure DECREASED by 22% from $27 million to $21 million.  How is this possible ?

Prior to Q1, 17% of ARA’s patients were on commercial insurance vs. 83% on government paid reimbursement plans such as Medicare / Medicaid. (13% were commercial non ACA, while 4% were commercial ACA patients).

In fact, for every patient who uses government insurance (the 83%), ARA actually loses substantial money. But no worry, the rate charged to private insurers (just 17% of patients) is so high that it makes up for all of the losses on the 83% and then provides ALL of the additional profits to the entire business (more than $100 million in EBITDA).

Following the exposure of ARA in the New York Times articles, the United Health lawsuit and the HHS actions, something interesting then happened at ARA between year end and Q1.

By Q1, ARA’s commercial mix dropped to 14% from 17%. This was largely due to the company’s stated “decision” to stop “assisting” patients into private insurance and out of government programs.  Most of the drop was due to the cessation of “assisting” Medicaid patients into private insurance.

But a mere 3% drop is no big deal, right ?!  Wrong !

Hypersensitivity:

Note that even though total revenues and total treatments increased during Q1, this tiny 3% drop in “commercial mix” caused ARA to lower EBITDA guidance by $25 million for 2017 – a 20% drop from previous guidance.

Because of the hypersensitivity to very small changes in these variables, analysts and investors have completely missed the going forward impact on ARA.

(But clearly the JV partners have not missed this at all.)

**  So why is ARA so much worse off than DaVita ?  **

It is worth observing that somehow ARA had historically been able to secure a commercial mix that was as much as 7 percentage points (more than 40%) above where DaVita has historically been, providing a dramatically higher slug of that super profitable commercial revenue.  But as a reminder, ARA has publicly denied that it was not engaged in any fraudulent steering of patients into commercial policies.

While ARA was able to hit a 17% commercial mix in 2016, DaVita has historically averaged around 10-11%, only once hitting as high as 12%. So to the extent that ARA’s 17% number “normalizes” along with further changes to the “charitable” assist model, I expect to see at least a further 3-6 point DECLINE in this commercial mix for ARA going forward. And that is certainly at a minimum.

So you do the math.  As we saw above, a 3 point change immediately shaved 20% off of EBITDA.  Next we can expect a full impact that is double to triplethe original amount.

And keep in mind, as DaVita and other industry players see further declines in commercial mix due to new policies and practices from insurance and the government, ARA should also experience further additional declines in commercial mix as well (even below the 10% level).  Investors should therefore not be surprised if EBITDA is cut in half.

A statement from DaVita’s recent conference call was then picked up by the StateOfReform website, highlighting the multiple headwinds and risks that are now affronting dialysis players from all sides.

[T]he concentration of profits generated by higher-paying commercial payor plans for which there is continued downward pressure on average realized payment rates, and a reduction in the number of patients under such plans, which may result in the loss of revenues or patients, and the extent to which the ongoing implementation of healthcare exchanges or changes in regulationsor enforcement of regulations, including but not limited to those regarding the exchanges, results in a reduction in reimbursement rates for our services from and/or the number of patients enrolled in higher-paying commercial plans[.]

In describing the “patient steering” scheme, StateOfReform said this:

The scheme that led to activity at multiple federal agencies is more problematic than improper 3rd party payments. It included enrolling people eligible for Medicaid and/or Medicare onto private insurance — at no cost to the patient thanks to the 3rd party payment — because private insurance, including in the individual market, reimburses at significantly higher rates than government programs. Same patient, same treatment, much higher reimbursement to the dialysis provider.

But again, please keep in mind that my opinion on this really doesn’t matter. Nor does the opinion of the sell side.

It is the opinion of the JV partners that matters. And their opinion is being loudly expressed by their sudden and ongoing rush to exercise their puts as fast as they can.

After multiple quarters of record put exercises, the further put exercises in Q2 should make this clear beyond any doubt.

**  So why haven’t investors and analysts figured this out ?  **

There are several reasons why analysts and investors have completely missed what is going on here and just how bad it is.

First, the JV/Put model is somewhat complicated.  There is JV equity that is owned by ARA corporate (and therefore ARA shareholders), there is separate equity owned by the JV partners (local doctors). Some of the doctors’ equity is subject to puts, while some of it is not subject to puts.

The point is that for the equity which is subject to put provisions, the JV partners are exercising nearly as fast as they possibly can.  With the remaining equity, there is just nothing they can do about it.

In ARA’s filings, there is certainly no disclosure which describes anything bluntly as “put exercise by the JV partners who are rushing for the exits”. And again, this is why the sell side can conveniently ignore it.

Instead, the ongoing filings just include an item called “purchase of non controlling interest” which does not sound particularly ominous.  Fuller disclosure of the put liability was originally included in the IPO prospectus, but that was in April 2016prior to any meaningful exercises by the JV partners.

The IPO prospectus stated that:

If the put obligations are exercised by a physician partner, we are required to purchase, at fair market value, a previously agreed upon percentage of such physician partner’s ownership interest.

Along with

We may be required to purchase the ownership interests of our physician partners, which may require additional debt or equity financing

The second reason that analysts have ignored this surging put exercise is that the nominal size of the put exercises appears relatively small relative to ARA.  But again, this is a question of hypersensitivity which they have missed.

Our complacent analysts may just view this $12 million as not being big enough by itself to have its own meaningful financial impact.

But it is not the financial impact of these puts that matters.  What matters is that it shows that the JV doctors are cashing in whatever vested equity they can nearly as fast as they are possibly permitted to do so.

With 50-80% of all vested options suddenly being exercised in any given quarter, and when that percentage is going straight up over time, this truly reflects a rush for the exits by the JV nephrologists on the ground.

Again, in the 6 years prior we had seen a cumulative total of $5.8 million in puts exercised.  Since the September quarter alone we have already seen double that, and the exercise rate vs. vesting appears to be accelerating.

It is these JV partners who know that business better than anyone else.  And they seem to be selling as fast as they can.

** What do the analysts say ?  **

Are these analysts actually even trying with ARA ?  No, they are not.  Here’s how we know.

So far there has been no notice from the sell side that these JV partners are suddenly exercising their puts as fast as they can, or that in a single quarterrecent put exercises exceed the cumulative total exercised since the inceptionof the company !!

Instead sell side analysts are doing the same thing with ARA that they did with Adeptus.  They are simply pitching hope that the worst impacts on commercial mix are now hopefully “behind the company”.

Because of ARA’s exclusive JV model, the accounting is moderately complex.  It involves accounting for a minority interest which fluctuates every quarter along with JV liabilities valued according to opaque “Level 3 Inputs”.   More than 40 entries are included in the equity table to reconcile the NCI’s.  There is even more, but you get the point.

If the analysts actually wanted to provide proper coverage on ARA, it would require a substantial amount of work each and every quarter.  The complexity means that we would expect to see a wide spread in their various price targets and assumptions between different analysts.

But in reality, ARA is just an “also covered” stock.  These analysts have every incentive to provide full coverage to giants like DaVita and Fresenius due to their market caps of over $10 billion.  But their coverage of ARA is just a perfunctory effort which is required to be part of the DaVita and Fresenius coverage universe.  With ARA, the research goal is simply to refrain from pissing off a company that may later pay some banking fees. Anyone who has worked on Wall Street should recognize this phenomenon.

For anyone who doubts this, you can observe the following:

Since the IPO, the analysts repeatedly place their targets at a safe level which is consistently in accordance with the pricing model known as “slightly above the current price”.  For even greater safety, all of these analysts then put price targets on the stock clustered in the same narrow price range vs. one another.

Despite the recent volatility in the industry and the complex accounting, all four analysts with recent updates placed targets within a very tight range of $22-23. That way no one needs to go out on a limb.

With ARA the analysts are just not paying attention to any of the details whatsoever. Not the imploding commercial mix. Not the surging put exercises by JV partners. Not the increasing litigation.

So now let’s look at a nearly identical situation where analysts covered a similar “high growth” health care stock which was backed and owned by one of the same banks’ large private equity clients.

**  Adeptus – a preview for ARA shareholders  **

If you want a clear preview of where ARA is headed, just look to the implosion of Adeptus Health (ADPTQ).  The parallels between ARA and Adeptus are really just too direct and obvious to ignore.  Just to make things simple, I will number the most obvious similarities.

Shares of Adeptus plunged from $120 in 2015 to near zero as the company began a rapid bankruptcy death spiral in 2016.

Adeptus was 1) a private equity backed 2) healthcare services IPO which 3) surged after it came public only to see 4) its results falter amid 5) overpayment issues which were 6) exposed in news reports over its 7) problematic business model. 8) Despite the emergence of obvious problems, the sell side banks were more than eager to hype the stock (and at Adeptus were then more than willing to accept the banking fees from the huge share sales by Adeptus’ private equity backer).  9) Numerous hedge funds naïvely piled into the stock.  Just like ARA, Adeptus’ public problems began with a simple newscast revealing the problems with overcharging. Even until the bitter end, and despite the increasingly obvious problems, analysts were telling investors that Adeptus was a “buy buy buy”.

Adeptus soon filed for bankruptcy and the stock now trades for around $1.00.

As highlighted in the Financial Times:

Adeptus Health, the largest operator of freestanding emergency rooms in the US, ended the day down 58 per cent to another record low, after it said there was “substantial doubt” over its ability to continue as a going concern. Its rise and fall is a parable of Wall Street: a perfect illustration of how banks like to crank and crank that hype machine.

Note that Adeptus had a full slate of investment banks running the company’s private equity backed IPO, ensuring broad research coverage going forward.  These same banks were quick to rake in millions in fees when the soaring share price allowed this same private equity backer to cash out of millions in stock at prices near the $120 peak.

As with ARA, the trouble started with a simple news story involving overcharging for procedures.

NBC news affiliate in Denver ran a documentary on what it claimed was a pattern of Adeptus patients being duped into paying huge sums for minor procedures

In retrospect, this news coverage signaled the “beginning of the end” for Adeptus.  This can be clearly seen from the stock chart which began an inexorable decline. When Adeptus delayed its (weak) financial results by a day and then announced emergency measures, the stock quickly fell 70% in a single day.

Also like ARA, despite the onset of obvious problems, the FT showed how analysts refused to relent, overhyping Adeptus shares to investors, even as it plunged all the way down into bankruptcy.

Seven analysts covered Adeptus at the time. Every one of them had a “buy” recommendation….

…The CEO left soon after. Then came the lawsuits. This week Goldman said it had been named as a defendant in “several” putative class actions alleging misstatements and omissions in offering documents. Other banks have been named in suits too, including Morgan Stanley, BofA, RBC and Evercore, according to court filings….

Then came the disclosures on Thursday, as Adeptus said it could not file its annual report until it fixed “material weaknesses” in controls and reporting. It also flagged a long list of charges — including up to $67m for uncollectible receivables.

And then the very best part !!!!

The stock closed at $2.79, down 98 per cent from the top.  Among the seven analysts still covering it, there were four “holds” and two “buys.”

If the parallels between Adeptus and ARA are not completely obvious to you then you should go back and read it again.

But again, don’t take my opinion for any of this.  And while you’re at it, don’t listen to the sell side either.

The most compelling indication of ARA’s problems is that of the nephrologist JV partners who are now rushing to exercise their puts as fast as they can for the first time in ARA’s history.

 

Disclosure: I am/we are short ARA.

Additional disclosure: This article represents the opinion of the author. The author is short ARA. The author may choose to conduct additional transactions long or short in one or more of the stocks or related securities mentioned within this article within the next 72 hours.

$OSIR After Criminal Investigation, Osiris Is Finally Delisted

Summary

  • In over 100 articles I have seldom used the word fraud to describe concerns. I reserve that word for the very worst situations where I have the highest confidence.
  • Within a few months after I expressed my fraud concerns on Osiris, we saw a CEO resignation, sweeping restatement of inaccurate financials and a criminal investigation.
  • Last Friday (after market close) Osiris announced that it would finally be delisted to the pink sheets.
  • I am short Osiris.
  • Lessons from Osiris can help people avoid catastrophic losses elsewhere.

Note: This article represents the opinion of the author. Nothing herein comprises a recommendation to buy or sell any security. The author is short OSIR.

Over the past few years, I have written at least 100 articles in various places online which have voiced my concerns over problems I have observed at publicly traded companies. Even when these problems are very significant, I almost never come out and explicitly use the word “fraud”. I reserve the use of that word for the true “worst of the worst” situations and where I also hold the very highest confidence. I generally only use the word “fraud” prominently once or twice a year.

Osiris Therapeutics (NASDAQ:OSIR) was clearly one of those situations. Here is the article I wrote on Osiris.

Following my article on Osiris, the company’s problems became evident quite quickly. Within 4 months, we saw a CEO resignation, a sweeping restatement of inaccurate financial statements and a criminal investigation. Obviously that was all quite bad. But it wasn’t until last Friday (March 10, 2017) that we finally got full closure. Last Friday, Osiris announced that it would be formally delisted from that Nasdaq and begin trading on the Pink Sheets as of this coming Tuesday. (As is often the case, when companies choose to release bad news, Osiris released this news well after market close on a Friday when most investors were already gone for the day.)

Yes, I am short Osiris.

Here are a few lessons we can learn from Osiris to help avoid catastrophic losses elsewhere in the market.

Lesson #1 – The cover up is often worse than the original problem. Don’t expect them to admit it.

As my regular readers know, I refuse to be rushed to publish anything I write. After I publish an article, companies will frequently put out aggressive public statements “refuting” my research and trying to discredit me. Rather than engage in back and forth banter, I typically remain mostly silent.

I act this way according to two very deliberate strategies.

Strategy #1: “The best way to expose a liar is to just let them keep talking”.

Strategy #2: “Make sure to give the guilty party enough rope to hang themselves”.

Osiris’ response to my article

As expected, Osiris did put out a press release to purportedly address my concerns and tout their supposed recent accomplishments.

Osiris Responds to Statements about the Company Recently Posted to Several Websites

In addition, I also received some angry correspondence from the company which included denials of what I had said along with veiled threats of legal action against me.

Yawn. I was happy to say nothing and just let the waiting game begin.

That glowing and bullish press release was dated January 19th, 2016.

On February 4th, 2016, just two weeks after the glowing and bullish press release, Osiris CEO Lode Debrabandere abruptly resigned from the company citing unspecified “personal reasons”. Please note that he had been with Osiris for 10 years and then suddenly resigned just two weeks after issuing a press release to assure investors of Osiris’ bright future and recent “transformational” developments.

On March 14th, 2016 (just 55 days after our glowing press release), the audit committee then came to the conclusion that Osiris’ previously issued financial statements should no longer be relied upon. This is completely consistent with the concerns I had raised in my article.

On May 24th, 2016 (just 126 days after the glowing press release), Osiris finally announced that it was the subject of a criminal investigation by the US Attorney’s Office. The criminal investigation was regarding Osiris’ accounting practices, which again was exactly the focus of my article.

[Osiris is currently delinquent in filing its ongoing financial statements with the SEC. Since the time of the announcement of the criminal investigation, Osiris has not filed any 10Q or 10K filings and has not otherwise provided any update on the criminal investigation that I could find. So the current status of that criminal investigation remains unclear.]

So there you have it. In my view, 3-4 months seems like a pretty sensible amount of time to wait between the glowing press release from Osiris and the formal criminal investigation. It’s all about being patient.

In general, it has been my extremely consistent experience that “the louder they protest, the guiltier they are”.

Once their actions come under public scrutiny, many troubled companies will often try their best to divert attention away from themselves and onto their critics. For example, many companies will often say that shorting stocks or writing short articles is somehow illegal. They will invent conspiracies to distract investors citing things like “illegal naked short selling” or invent various “organized conspiracy plots” which are supposedly acting to drive down their share prices. They will often claim that they are initiating legal actions either through the courts or through the regulators such as the SEC.

Forcefield Energy’s response to my article

With Osiris, it took around 4 months for the Feds to launch their criminal investigation. To some people, that might seem pretty fast.

But with Forcefield Energy (NASDAQ:FNRG), it only took a few days for the Chairman to be arrested and the stock to be halted and then delisted. Now that was really fast.

As with Osiris, my article on Forcefield was one of the extremely rare instances where I felt comfortable using the explicit word “fraud” in my article.

My article was published on April 15th.

The company put out its aggressive response, denials and threats of legal action against me on April 17th (just two days later).

And on April 20th (just 5 days after my article), the Justice Departmentannounced that it had arrested Chairman Richard St. Julien as he was about to board a plane in an attempt to flee to Central America. On that same day, Forcefield stock was halted and then eventually delisted.

It was subsequently disclosed by the Justice Department that 9 individuals were indicted on sweeping fraud charges totaling $130 million.

Sadly, the depth and extent of the fraud at Forcefield are pretty much identical with what we see at other stock promotions and frauds.

According to the DOJ:

They took a company with essentially no business operations and little revenue and deceived the market and their clients into believing it was worth hundreds of millions of dollars through a dizzying round of unauthorized trades and deceptive promotions. In the end, the deceived investors were left holding the empty bag,”

Again, the implosion happened in just 5 days and Forcefield went from $7.50 to zero.

I knew that Forcefield was going to be a homerun short trade as soon as I saw the public statements being issued by the Chairman. Again, “the louder they protest, the guiltier they are”.

The “rebuttals” to my article from Forcefield are worth looking at in more detail. The press release reads like a boiler plate script which has been repeated over and over again by numerous fraudulent companies as they seek to divert attention from their own impending calamities.

While the specific wording varies from case to case, the elements are always the same in these public denials.

First, highlight that the author is short. Imply that this is somehow bad or even illegal. (It is not). State clearly that the company is acting to protect its shareholders from short sellers. Standard stuff.

Second, flatly deny, deny and deny all content of any negative and say that it is inaccurate. Don’t worry about refuting specific evidence in the article. Occasionally provide a few clever obfuscations which, in reality, don’t directly address the actual original concerns raised.

Third, make high profile and scary sounding threats of legal action through the courts or the SEC. Clearly if the company were guilty, they wouldn’t deliberately seek to involve the courts or the regulators, right ? (Wrong. By this point, these companies have nothing to lose. I have observed that in most cases any threats of supposed SEC complaints or lawsuits by these fraudulent companies turn out to be either sham efforts or outright lies.)

The quote from the DOJ above shows just how empty and utterly fraudulent Forcefield really was. Yet here are a few very sincere sounding quotes from Forcefield which came just 3 days before the Chairman was arrested. You will often see nearly verbatim quotes from other fraudulent companies once they come under public scrutiny.

From Forcefield’s press release:

[Here is the standard part about blaming shorts and claiming information is wrong]

The opinion was written by an individual investor, not a registered financial advisor, who has disclosed owning a short position in the Company’s common stock… The Company maintains that the article contains material inaccuracies about its management, business and prospects.

[Here is the standard part about “protecting investors” and pursuing legal remedies]

Richard St. Julien, Forcefield’s Chairman stated, “We are not going to stand by and allow our Company, officers and directors, employees and shareholders to continue to suffer through what appears to be an orchestrated short selling attack based on misinformation. We intend to defend ourselves and pursue all possible remedies against the allegations asserted in the opinion. Further, we will provide our shareholders and investment community a business update in a release pre- market on Monday April 20, 2015.

[Here is the standard part blaming some supposed conspiracy or short sellers and the part about “initiating legal action”.]

In addition, Forcefield stated that it had requested that a regulatory agency review the trading activity in its common stock in addition to any relationships, arrangements and commonalities between short sellers and others.

Again, within 72 hours of making those strong and reassuring statements to the public, Chairman Richard St. Julien was sitting in the custody of the FBI and DOJ.

A response from Galena Biopharm

In February of 2014, Adam Feuerstein of TheStreet.com published a scathing article on Galena Biopharma (NASDAQ:GALE) describing undisclosed paid stock touting scheme which Galena insiders used to dump their shares at inflated prices. The authors behind these paid articles were assuming false identifies, often pretending to be doctors, biotech experts or hedge fund managers. Their supposed “expertise” always predicted in various articles that Galena would soar to new heights. This in turn did cause the stock to rise.

After Feuerstein’s article, the share price plunged and Galena was quick to issue a letter to shareholders which it said was being done (of course) “as a service to our shareholders”.

In Feuerstein’s article, he had cited online evidence of paid promotion behind Galena. But once highlighted, much of this evidence began to disappear from online locations.

Once the evidence disappeared, Galena then felt confident to describe Feuerstein’s writing as “tabloid like”, “accusatory” and “negative”.

Galena stated

The only facts in Mr. Feuerstein’s most recent article that are remotely accurate are that Galena previously engaged the DreamTeamGroup and that insiders at the company, including me, divested shares in mid January. All other accusations in this article – as with his prior reporting on Galena – are specious and conveniently arranged to create controversy.

As soon as I saw this public statement from Galena, I literally laughed out loud. I cackled. I guffawed. I chortled.

Once again, “the best way to expose a liar is to just let them keep talking”.

Unbeknownst to Galena or Feuerstein, at this very time, I was already elbow deep into my own investigation into the paid promotion behind Galena.

Shortly thereafter, I released the smoking gun documents obtained directly from the guilty promoters which described in detail the intimate involvement of Galena management in actually coordinating and even editing the undisclosed paid articles which were being published during an ongoing paid campaign using the Dream Team Group.

Behind The Scenes With Dream Team, CytRx And Galena

Slam-Freakin-Dunk.

Following my article, Galena quickly became the subject of an SEC investigation. CEO Mark Ahn was fired following the scandal. A wide range of civil lawsuits ensued.

[In December of 2016, Galena announced that it had reached “an agreement in principle” to settle with the SEC. However, just a few weeks later in January of 2017, Galena then announced that it was now under criminal investigation by the US Attorney’s Office and the Department of Justice for separate issues related to the marketing and promotion of fentanyl.]

Prior to the scandal (and as a result of the paid promotion), Galena had traded as high as $8.00. Galena now trades for around 58 cents.

The aggregate lesson from these examples above should be simple. Once there are indications that a company has misled investors in the past, it should come as no surprise that they are willing to mislead investors in ongoing press releases. History has shown that fraudulent companies are more than willing to put forth massive and outlandish statements that are absolutely and utterly false. Oftentimes, they will literally say anything regardless of how ludicrous or unsubstantiated it might be.

Lesson #2 – Markets are rational in the long term but irrational in the short term

As much as I like to take credit for exposing Osiris, the fact is that I was not the first one to publish concerns about the company.

Prior to my article on Osiris, author Edward Vranic, CFA had published no less than 3 very concerning articles highlighting his own concerns about Osiris. I felt that his concerns were extremely valid and were very well articulated.

Despite the concerns raised by Vranic, the stock barely budged, sticking closely to a price of around $10. The market simply didn’t care. For the market to ignore such significant information was truly irrational.

Once I observed that the market didn’t care about Vranic’s concerns, I naturally assumed that it would also not care about any subsequent concerns that I might have just a few weeks later. But for the good of the market, I chose to publish my research anyway.

I was quite surprised to see the stock quickly drop by as much as 40% following my article. The concerns that I raised were entirely different than those raised by Vranic, but I felt that they were largely of the same magnitude.

The fact that the market reacted so strongly to one set of concerns while virtually ignoring the other again shows how irrational and unpredictable that markets for these small cap controversial stocks can be.

And then the mystery deepens even further.

Following the announcement of the financial restatement in March, Osiris plunged to a new low of $3.55. That seems pretty rational so far, although I would have possibly expected a bit of a deeper decline.

But then for some reason the stock steadily rebounded to prices well above $6.00. This was true even after the criminal investigation was announced.

Ultimately we can see that Osiris is now being delisted to the pink sheets. The stock will now grind down to well below $1.00 where it belongs.

The lesson to be learned here is this:

In the short term stock prices can remain irrationally elevated even in the face of bad news.

In the long term stock prices will eventually converge to their fair value.

The problem is that the demarcation point between “short term” and “long term” often happens in just an instant, leaving those who own the stock subject to immediate and unavoidable losses.

The lesson here is that holding on to shares of problematic and controversial small caps is demonstrably a very bad idea. Even if they seemed immune to their problems yesterday, they will often plunge suddenly and without any advance notice, leaving investors no opportunity to get out.

Lesson #3 – Sell side research is generally worthless

At the time of my article on Osiris, numerous concerns were already starting to leak out into the public domain. Ed Vranic had already been quite vocal and the concerns I had raised were all based on publicly available information. Clearly the stock was headed dramatically lower from its then level of around $10.00.

But for some reason Piper Jaffray continued to support the stock with a whopping $28 price target. Even without the baggage of obvious malfeasance, Osiris’ underlying business simply couldn’t justify such a lofty price target.

Piper continued to maintain bullish targets even after my article, and as the stock hit $5.00. Piper continued to maintain its bullish targets even after the CEO resigned. And somehow Piper continued to stay bullish even after the audit committee recanted the company’s historical financials as being inaccurate.

Only in June of 2016 (just days after the announcement of the criminal investigation) did Piper finally “suspend” its rating of Osiris. At the time, it had still maintained a $12 target on Osiris.

It continues to puzzle me how sell side analysts continue to have any impact on share prices at all. I really don’t know why anyone continues to listen to them. It is widely known that as much as 95% of sell side targets are with Strong Buy, Buy or Hold recommendations. The occasional Sell rating is hard to find and inevitably comes well after the share price has already plunged, making such a “recommendation” completely useless to investors. There is simply no incentive for sell side analysts to ever put a Sell rating on a stock. As a result, they just don’t do it, regardless of how horrific the stock has become.

And yet for some reason we can still see share prices often pop when some sell side analyst initiates coverage or raises his target.

Despite my general disdain for sell side analysts, there is one guy who deserves a special positive shout out.

Very early in the game, when the stock was around $15, Brean Capital analyst Jason Wittes downgraded Osiris to a Sell with a target of $8.00. He also cautioned investors that emerging concerns could send the stock to below $5.00.

Wittes deserves strong kudos for being right, for being early and for accurately predicting quite closely the near term impact on the share price. He also deserves extra kudos for demonstrating very rare courage in moving against the herd by actually putting out a Sell rating at all.

Sadly, coverage and analysis like that from Witte is the vast exception to the rule.

Conclusion

When looking at fraudulent companies, share price implosions often occur in stages.

With Osiris, the first phase only took a few weeks after my article to begin, starting with the resignation of the CEO. This intensified once we saw restatements of inaccurate financials and a criminal investigation a few months later.

All of this fallout occurred not long after Osiris put out a press release designed to reassure investors and “refute” critics like me. I hope that investors will learn the lesson that such press releases and the statements they contain should be viewed with a very large grain of salt. The lesson I have consistently observed is that “the louder they protest, the guiltier they are“.

In many cases, companies which demonstrate clear underlying problems will be headed for ultimate delisting and implosion. But in many cases their stocks will take a pause on the way down, typically after initial plunges of around 50%. The final plunge to the pennies will then come with little notice when the company is ultimately delisted.

Sell side research is generally not worth the paper it is printed on. In most cases, I ignore it completely. Although there are a few exceptions.

In the article above I only cited a few examples to support these lessons. Each of these were based on articles written by me.

But aside from Osiris, Forcefield and Galena, I have had similar experiences following many others of my past articles. After my articles are published, we have frequently seen some form of aggressive response and then some moderate level of share price decline. Yet ultimately we have consistently seen these stocks eventually plunge by 80-95% from their promotional highs and also become the subject of either SEC investigations, class action lawsuits or forced resignations of senior management.

Disclosure: I am/we are short OSIR.

$CETX Cemtrex: Documents and Photos, All Signs Point to Fraud

Summary

  • On Tuesday, Cemtrex fell 13% on huge volume. On the preceding trading day, Cemtrex’s banker Source Capital quietly had its SEC and FINRA registrations terminated following multiple violations.
  • Over $1 million has been paid to notorious stock promoters sending CETX soaring from below $2. Heavy undisclosed selling by CETX insiders during paid promotion.
  • DOCUMENTS: Founder Aron Govil is secretly paying promoters via an undisclosed entity with little or no other activity. Using same promoters behind imploded frauds Forcefield Energy and Code Rebel.
  • PHOTOS: CETX’s supposed audit firm traced to vacant strip mall in Texas, no operations. Controlling partner was banned by SEC for multiple fraudulent audits, under multiple firm names.
  • Nearly $100 million in revenues, from 4 countries on 3 continents. Cemtrex pays auditor just $20,000 per year in audit fees to sign off on financials. Non-sense.

Note: This article represents the opinion of the author. Nothing herein comprises a recommendation to buy or sell any security. Following exposure of the problems listed below, I expect that many of the links cited may be changed or removed by the parties implicated. I have made various efforts to retain pdf copes and screen shots where possible. The author is short shares of CETX. 

Note: The short interest in Cemtrex (NASDAQ:CETX) is extremely low at just 400,000 shares (just a single day’s trading volume) such that this has created a very interesting situation.

Recent trading

Yesterday we saw shares of Cemtrex fall by 13% on nearly 1 million shares of volume with no apparent news. But in fact, on the previous trading day (Monday was a holiday), Cemtrex’s investment bank, Source Capital, had its SEC and FINRA registrations terminated nationally and in all states.

There was no announcement and no press release that I could find. The only way to find out was by checking FINRA’s Broker Check website. FINRA has still not uploaded the details of the latest violations, but we can see from a Florida lawsuit that Source was forced to pay a massive settlement to retirees who were sold risky and unsuitable investments that quickly went bankrupt.

To me, this looks like the end of Source Capital. And it followed past violations by Source brokers including forgery, selling unregistered securitieswithholding material information from investors and dealing at unfair prices.

The fraud

As my regular readers know, I often express significant concerns about problems I find with publicly traded companies. But these readers know that I will seldom come out and actually use the word “fraud”.

But I feel comfortable that the extensive use of the word “fraud” is entirely appropriate in this article for the reasons below. The points I will make below are supported by on the ground photographs as well as official government documents from various agencies.

1. Cemtrex is being heavily promoted by a promotion firm known as “Small Cap Specialists” (AKA “SCS”). Past SCS promotions have been repeatedly halted or delisted due to financial irregularities or outright fraud. (Examples include delisted frauds Forcefield Energy and Code Rebel, among others). On its website, the SEC has gone so far as to specifically warn investors about these exact type of promoters as an indication of micro cap fraud.

2. Documents indicate that Aron Govil is paying this same promoter SCS to promote Cemtrex via wire transfers from an undisclosed entity in New York. The paid promotion by Cemtrex insiders has not been disclosed to Cemtrex investors. In the past, I have seen numerous examples of other companies engaged in similar undisclosed paid promotions that resulted in Federal charges or lawsuits for securities fraud.

3. As the share price has soared due to promotion, documents show that shares held by Cemtrex insiders (Aaron Govil, Saagar Govil and CFO Dela Rama) have been decreasing substantially during 2016, yet Cemtrex insiders have failed to disclose any sales on Form 4’s during 2016. On places like Twitter, the Govils continue to tout the stock, encouraging retail investors to buy.

4. The controlling partner behind Cemtrex’s auditor was banned by the SEC and PCAOB for conducting fraudulent audits or reviews of public companies while performing little or no work and without even being licensed. Cemtrex’s auditor continues to claim that the firm is run from an office in Texas. But photos show that this address traces to a long-since vacant strip mall. The audit firm is not even licensed to practice in Texas. The only listed phone number in the US has been disconnected. That partner has repeatedly audited public companies under the guise of differently named audit firms which have then been shut down. When one audit firm gets shut down, he has repeatedly created new ones and then audits the same clients, using the same personnel, reporting the exact same address in Texas. Cemtrex’s prior auditor was shut down by the PCAOB and is now classified as a “prohibited service provider“. Despite having revenues of nearly $100 million and operations in 4 countries across 3 continents, Cemtrex has only paid these auditors a mere $15,000-$20,000 per year to “audit” its complex financials.

5. The investment banks and IR firms hired by Cemtrex (including Source Capital) have repeatedly represented other heavily promoted companies that have been promoted by SCS or other promoters. There has been long running and significant involvement with companies, individuals or activities implicated in securities fraud.

Background

Over the past few years, I have exposed dozens of stock promotions, pump and dumps and outright frauds. The result tends to be the same in each case. After these stocks are exposed, their share prices fall by at least 80% to just pennies. In some cases, after I have exposed these companies, we have seen SEC investigations, criminal indictments, management and auditor resignations and other fallouts. In some cases, this has happened within just days of my article being published. In other cases, the stocks have simply imploded without further fanfare.

With Cemtrex, there is a reason why the numbers appear to be “too good to be true”. There is a reason why there has been a surge of glowing media articles touting Cemtrex and its management. And there is a reason why the stock keeps selling off even when supposedly good news is released.

There are clear reasons why hundreds of small retail investors have been duped into buying the stock and these are all thoroughly debunked and exposed below.

Company overview

Cemtrex has two business segments:

Electronics Manufacturing Services (“EMS”) provides electronic manufacturing services, including product design and sustaining engineering services, printed circuit board assembly and production, etc.

Industrial Products and Services (“IP”) offers services for in plant equipment erection, relocation, and maintenance; air filtration and environmental control products; and monitoring instruments, for measurement of emissions of Greenhouse gases, hazardous gases, etc.

Cemtrex was founded 15 years ago by Aron Govil. Govil also runs Ducon Technologies which operates out of the same address as Cemtrex and which owns Cemtrex shares. Through his personal and Ducon holdings, Aron Govil is the largest shareholder in Cemtrex.

In 2008, Govil appointed his 23 year old son, Saagar Govil, into various executive and board positions at Cemtrex. Young Saagar had just graduated from undergrad that same year in 2008, with no prior reported work experience.

Just 2 years later, at the age of 25, Saagar was appointed CEO of Cemtrex and father Aron took the role of executive director and board member.

Following the appointment of Saagar Govil as CEO, Cemtrex quickly embarked upon a slew of acquisitions, primarily of obscure companies in foreign countries well outside of the US.

Cemtrex has employed an aggressive IR and media relations firm to obtain an avalanche of positive media coverage around the Govils and Cemtrex.

Saagar has recently been the subject of a flood of glowing media attention due to his young age and the apparent rapid growth of Cemtrex’s revenues.

Between 2012 and 2016, reported revenues grew from $12 million to $94 million, largely driven by acquisitions of insolvent companies in overseas markets, which then contributed heavily to Cemtrex’s results as soon as they were acquired.

Key points underlying fraud thesis

Again, based on my past experiences and observations, I believe that there is a very strong chance that Cemtrex gets delisted outright and will go to zero.

The key points I will address are as follows:

Point #1 – The massive paid by promotion, secretly paid by Cemtrex management

Point #2 – Cemtrex insiders make undisclosed sales while pushing retail investors to buy

Point #3 – Cemtrex’s defunct auditor gone missing, history of fraud

Point #4 – The 3rd party service providers

Point #5 – Financial and disclosure “irregularities” and inconsistencies

Point #1 – The massive paid by promotion, secretly paid by Cemtrex management

In 2016, the SEC put out an Investor Alert Bulletin entitled: Fraudulent Stock Promotions.

In this, it warned that:

Be especially cautious regarding stock promotions if there are any warning signs of microcap fraud including:

· The SEC suspended public trading of the security or other securities promoted by the same promoter.

· Increase in stock price or trading volume linked to promotional activity. …

This is precisely what we see with Cemtrex and the promotions being run by a firm known as Small Cap Specialists (AKA “SCS”). SCS has been behind dozens of imploded stock promotions including a number of high profile frauds which were halted and / or delisted by the SEC.

SCS happens to be the exact same promotion firm that Aron Govil is paying under an undisclosed entity name to run a pump campaign on Cemtrex. SCS has now been promoting Cemtrex for over 1 year. During that time, the share price quadrupled.

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First I will show how SCS repeatedly runs paid promotions on fraudulent companies which are then halted and/or delisted.

Second I will show the documents which show that Aron Govil is paying SCS to promote Cemtrex, using an undisclosed entity name.

And in the next section I will then show how Cemtrex insiders are secretly selling shares during the paid promotion campaign, without disclosing the sales to investors.

Evidence of various paid promotions on Cemtrex along with the payments involved can be found at promotion tracking sites such as Hotstocked.comand Stock promoters.com. But these sites typically only capture a fraction of the promotions under way.

As we can see from these sites, a well oiled stock promotion machine began aggressively pumping Cemtrex through a wide variety of online channels. So far, over $1 million has been paid to stock promoters.

I include a partial screen shot showing various paid promotions on Cemtrex at the bottom of this section, or just click the links above. Here are just a few of the examples. There are dozens and dozens more, each of which tend to cost from $10,000 to $50,000 a pop.

I will demonstrate below that Aron Govil is behind Southern Steel & Construction which is paying SCS. SCS has been responsible for numerous paid promotions on Cemtrex.

This aggressive paid promotion is what took the stock from below $1.70 to over $7.00 in 2016.

(For more details on the past frauds or promotions by SCS which were halted, delisted or imploded, see Appendix A)

Aron Govil’s hidden paid promotion using SCS promoters

Here is just one example of an SCS promotion of Cemtrex which was paid for by an entity called “Southern Steel and Construction”. This promotion was dated October 2016, but it notes that SCS had been covering Cemtrex for a full year prior.

We can see below that just two or three days coverage cost “Southern Steel” $30,000, which was paid via bank wire.

(Note: This single payment to SCS for just 2-3 days of stock promotion is more than all the audit fees paid to its auditor Bharat Parikh for the full year for any of the last 3 years !)

The SCS promotion begins with:

Good morning everyone, This week’s featured profile is one of our favorite small cap’s since our initial coverage in October 2015. Cemtrex, Inc. (NASDAQ: CETXCETX has been an amazing growth story through organic and acquisitions since our initial coverage last year. We are excited about what may be in store for this company going forward.

Here is a screenshot noting payment of $30,000 by Southern Steel for just 2-3 days coverage:

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So just who is Southern Steel ?

The only individual identified on a search from the New York Department of State is Aron Govil at 19 Engineers Lane (which is Cemtrex’s address).

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First off….so New York’s corporate records for Southern Steel, which is paying for Cemtrex promotions by SCS, lists only Aron Govil at the same address as Cemtrex.

And then second….Southern Steel’s entity status is listed as “inactive,” meaning that since August 2016 it has engaged in little or no other business activity other than paying SCS to promote Cemtrex.

In fact, this information is a bit difficult to find. By default, the NY State database only shows “active” corporations. So when searching for this, one must opt to explicitly search for “all” corporations, both Active and Inactive.

Again, this is just a single example of a paid SCS promotion.

(For a screenshot of additional Cemtrex promotions please look in Appendix B)

Point #2 – Cemtrex Insiders make undisclosed sales while pushing retail investors to buy

When a corporate insider makes sales of their own stock, this is very material information to outside shareholders because presumably insiders know much more than the rest of us.

When an insider (management figure, director, or 10% holder) makes an initial purchase, that insider is REQUIRED to report the transaction on SEC Form 3.

Subsequent transactions by such insiders (either buys or sells) are then REQUIRED to be reported on SEC Form 4.

The Form 4’s are very important because they REQUIRE the insider to disclose:

· the date of transaction

· the number of shares transacted

· the share price received

Retail investors in Cemtrex have tried to remain confident under the assumption that management is holding strong and not dumping shares.

Precisely during the time of the paid promotion campaign, and along with the soaring share price, the number of shares held by Aron Govil, Saagar Govil and CFO Renato Dela Rama have all decreased significantly. The total decrease in their shares amounts to nearly 1 million shares, amounting to as much as $7 million in proceeds in 2016. You can do the math yourself: During 2016, Cemtrex’s share price ranged from $1.65 to $7.38.

Yet no form 4’s have been filed to disclose any share sales from any Cemtrex insiders whatsoever. Here is a link to all of Cemtrex’s SEC filings.

It truly defies all common sense that ALL members of managementhad their shareholdings decline substantially while precisely NONE of them has filed a single Form 4 to disclose it.

For those who wish to double check for themselves, here are the reference SEC filings.

Ducon Tech Form 4 filed 2015

Cemtrex Proxy filed 2016

Cemtrex Proxy filed in 2017

The table below shows the number of shares held as of each of those dates. We can see that for each of Ducon, Aron Govil, Saagar Govil and Renato Dela Rama, the number of shares has declined substantially.For the directors, we do not know, because they never filed the required Form 3’s to disclose their ownership.

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Ducon Technologies

In November of 2015 (exactly when the paid promotion from SCS began), Ducon Technologies disclosed a purchase of 65,732 shares at a price of $2.55 for a total amount of $167,617. As disclosed, this took Ducon’s holding of Cemtrex common stock to a total of 433,219 shares. Ducon Technologies is controlled by Aron Govil, who is behind the entity paying for the undisclosed stock promotion.

But according to the most recent Proxy filed in January of 2017, Aron Govil’s Ducon Technology now only has 102,951 shares. It therefore got rid of 330,268 shares during 2016. Because there were no Form 4’s filed, we don’t know the dates or the amounts of any sales. But we can see that the share price ranged from below $2 to above $7 in 2016. Therefore, depending on when its shares were sold, Ducon Technology could have sold up to $2.3 million.

Aron Govil

By comparing the Proxy’s issued in 2016 and then 2017, we can also see that shares held under Aron Govil’s own name declined by 222,049 shares in 2016. Again, depending on when these were sold, they could have been worth up to $1.8 million.

Saagar Govil

As we will see, Saagar Govil’s share holdings increased by 100,000 during 2016. But during the year he also awarded himself 400,000 new shares via option grants, such that his position should have increased by 400,000. So clearly his net position actually declined by 300,000 shares.

For Saagar Govil, the 300,000 decline amounts to up to $2.1 million in 2016 assuming the sale of stock at share prices up to $7.00.

In September 2016 (with the stock having just hit new highs for the year), Saagar Govil also purchased an upscale condo in New York valued at precisely $2.25 million.

(The timing, the prices and the disclosure omissions around Saagar’s 400,000 option grants also leads me to the question of if these were backdated to occur at artificially low prices. I will show the detailed documentation of in a section below).

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CFO Renato Dela Rama

Moving on, we can also see that the number of shares held by the CFO also declined by 19,833, again with no Form 4’s being filed. Depending on when the sale was made, this would have a value of up to $138,831 (or more than triple his reported salary).

The Directors

With directors Sunny Patel and Shamik Shah, we can see that both directors report owning a few thousand shares worth up to $30,000-$40,000. But no initial Form 3’s were ever filed to disclose when they received these shares or at what price. We also don’t know how many shares they initially received in total, such that there may have been substantial selling here as well. Typically, new directors are awarded shares as of the date they join the board. For both of these directors, that would have been the Spring of 2015. New shareholdings by directors are ALWAYS required to be filed to the SEC, but NONE were ever filed by these directors.

The use of Twitter, StockTwits and online message boards to promote Cemtrex

In my past articles I have exposed clearly how paid stock promoters will also infiltrate online message boards, social media (Twitter) and online financial blogs. They then pose as independent individuals who rally the enthusiasm behind their promoted stocks. Once you know what to look for, these paid promoters often become obvious online. They suddenly appear out of nowhere and begin aggressively cheering on a certain stock. At some point (when the promotion is ending) they disappear just as quickly and this is when we see the stock start falling apart.

In addition, all throughout the paid promotion campaign, both Aron Govil and Saagar Govil have been actively cheerleading Cemtrex’s stock price on places like Twitter, encouraging retail investors to BUY BUY BUY. Obviously, this is highly unusual for any executive of any publicly traded company. They are supposed to be running a company, not sitting in front of their computers, Tweeting to promote the stock price. It also raises the potential for Reg FD violations. This is why we almost never see CEOs publicly touting their own stock on Twitter.

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Point #3 – Cemtrex’s defunct auditor gone missing, history of fraud

Up through 2014, Cemtrex was using a defunct auditor called Li & Co. But Li & Co. was shut down by the PCAOB. During the investigation, Li & Co. simply refused to provide subpoenaed information to the investigators. That defunct audit firm is now listed as a “Prohibited Service Provider” and is no longer allowed to provide audit services.

Following that, Cemtrex began using Bharat Parikh & Assoc as an auditor. Bharat Parikh is a small audit firm based in India, not the US, but with a supposed office in the US for auditing US clients. Even in recent weeks on Cemtrex’s just issued 10K filing, it continues to list Bharat Parikh’s office address in the US as 4940 McDermott Rd., Plano, TX.

Here is a screenshot of Bharat Parikh’s signature from Cemtrex’s form 10K filed with the SEC just a few weeks ago, dated December 28, 2016.

In fact, this corresponds to a vacant strip mall office in Dallas. Here are some photos of that vacant office space at 4940 McDermott Road. The photos were taken just a few days after that SEC filing came out.

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Clearly even though these offices appear to have been vacant for quite some time, Bharat Parikh continues to claim to the SEC that he is running a team that is performing audits out of this office.

In addition, the US phone number listed on the auditor’s website has been disconnected.

We now encounter a host of problems:

First, (obviously) the fact that Cemtrex’s auditor claims to be running a busy audit firm out of a long-since vacant building in a strip mall is troubling. Likewise, the disconnected phone number is equally troubling.

Second, Texas State Board of Public Accountancy has no record of Bharat Parikh even having a license to provide audits for public companies. Click the link above to search the database. Enter in any combination of Bharat+Parikh and / or BPA, etc. There is nothing.

Third, Bharat Parikh & Associates is actually controlled not by Mr. Parikh, but by Mahesh Thakkar who holds a 51% stake in the auditor. Thakkar was banned by the SEC and the PCAOB due to accepting fees to provide fraudulent audits, and also for operating without a license to even provide audits at all. At the time, he was running an audit firm under a different name (Thakkar CPA / The Hall Group). But it was actually operated out of the same address (4940 McDermott), with the same group of personnel auditing the same clients. It is no coincidence that past clients from that partner then ended up simply switching over to the “new” firm using the “new” name Bharat Parikh (i.e. Cemtrex’s auditor) out of the same exact address. Thakkar has operated audit firms using multiple names, changing the name of the firm each time he gets shut down. Various names used by Thakkar include: The Hall Group, Thakkar CPA, and Bharat Parikh and several others. Most recently he has attempted to use the name TMK LA (in which Mr. Bharat Parikh is listed as his partner).

Fourth, as we will see, Cemtrex pays this absentee auditor a mere $15,000-$20,000 in audit fees per year, despite claiming revenues of nearly $100 million from operations which span 4 countries and 3 continents. As highlighted by CFO.com, smaller firms tend to pay roughly $5,000 in audit fees per million dollars of revenue. That should place Cemtrex at nearly $500,000 in expected audit fees (even without sprawling international operations).

Here is how we know all of this.

If you look closely at the picture of 4940 McDermott, you can make out the glue outline of the words “Perfect Tax and Finance“. Perfect Tax was founded and operated by Mahesh Thakkar, CPA and lists 4940 McDermott as its address. Thakkar partnered with Bharat Parikh out of this same address, which is again the same address that continues to be listed for Bharat Parikh in Cemtrex’s SEC financials even now.

Here we can see that Bharat Parikh and Thakkar listed as General Partners in an LP called “TMK LP” that claims to provide CPA services, again from 4940 McDermott Road.

We can also see below from the Texas Secretary of State that Thakkar was listed as the CONTROLLING PARTNER in Bharat Parikh Associates, with a 51% stake and he uses the same address as Bharat Parikh, both in India and the US. Once again, this is 4940 McDermott Rd.

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HERE we can see where Bharat Parikh controlling partner /predecessor Thakkar was then barred by the SEC from practicing accounting for public companies.

HERE we can see where its registration was revoked by the PCAOB.

We can see then that prior to taking control of Bharat Parikh, Thakkar had previously run his audit shop under a different name in Texas, again covering public companies. This firm was Thakkar CPA d/b/a “The Hall Group CPA’s”.

As with all of the other firms listed here, of course Thakkar CPA’s operated out of 4940 McDermott, the same vacant strip mall. (In the link above, simply type in the firm name of “Thakkar”).

Here we can see that Thakkar has now been officially suspendedfrom practicing accounting due to various violations including “violating auditing standards“, “violation of rules of professional conduct” and “lack of fitness to serve the public as a professional accountant”

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In its previous incarnation, Thakkar had formed Thakkar CPA’s to perform public company audits. But he had two problems. First, he had no PCAOB license to perform audits and second he had no clients.

As a result, he simply bought an existing audit firm called “The Hall Group CPA’s” which had a number of existing public company clients. Thakkar then began signing off on audits for these clients. But according to the SEC, he never became registered with the PCAOB, which is required for auditing public companies.

And here we can see where audit clients such as Pink Sheets traded Inolife simply switched over from the audit firm calling itself “Thakkar/Hall Group” to the one calling itself “Bharat Parikh” to complete their audits by a supposedly “new firm”operating out of the exact same address by the same group of people.

According to the SEC complaint, there were actually a host of deep and concerning violations by Thakkar/Hall. You can click below to read them all, but we will focus on just a few of them below.

According to the SEC:

These proceedings arise out of Thakkar CPA, PLLC d/b/a The Hall Group CPAs (“Thakkar CPA” or “successor firm”) issuance of 15 public company audit reports while it was not registered with the Public Company Accounting Oversight Board (“PCAOB”). Thakkar CPA’s audit reports misrepresented that the firm was properly licensed and registered with the PCAOB and falsely stated that it conducted audits in accordance with PCAOB standards.

The Hall Group, Hall, Helterbran, and Cisneros collectively failed to conduct at least 16 annual audits and 35 quarterly reviews in accordance with PCAOB standards in at least three ways: (1) they repeatedly failed to prepare adequate audit documentation in connection with audit and review engagements; (2) failed to conduct – or failed to obtain – an engagement quality review (“EQR”) of audit and review engagements by a qualified reviewer; and (3) on at least four engagements, The Hall Group and Hall performed audit services while the firm’s independence was impaired. As a result, The Hall Group falsely stated that it conducted its audits in accordance with PCAOB standards in at least 16 annual audit reports for eight issuers. Additionally, Hall, after becoming CFO of DynaResource, Inc., allowed Thakkar CPA to provide audit services to DynaResource, Inc. even though he knew he had a direct financial interest in and a business relationship with the company’s external audit firm.

So Bharat Parikh’s controlling partner / predecessor was banned because on 35 separate occasions it did not prepare audit documentation, it did not have a partner even conducting audits and it falsely attested that it had properly conducted audits.

Basically, Thakkar was getting paid small amounts of money to sign off on these audits without really doing any work at all !

In addition, the firm signed off on audits in a company with which it clearly had a direct financial interest and was therefore not independent.

Here is why this matters. (And this should become quite obvious).

Cemtrex purports to generate revenues of nearly $100 million coming from 4 international subsidiaries spanning 3 continents. Presumably this makes Cemtrex relatively complicated (and expensive) to audit. This audit then gets even more expensive when the company needs to integrate ongoing acquisitions of totally new businesses. Any realistic cost assessment of such audit work for any normal company could run as high as $500,000-$1 million. Easily.

Yet in Cemtrex’s 10K we can see that paid it’s absentee Indian auditor a mere $20,000 to perform its audit work in each of the last two years! And in the previous year, audit fees amounted to just $15,000.

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Even for a small company with operations in just a single city, no auditor can justify even preliminary work for just $15,000-$20,000. For a company operating in 4 countries across 3 continents, this is just patently absurd. And it seems very consistent with the history of Thakkar / Hall etc. signing off on so-called “audits” without actually doing any real work.

In my view, the $15,000-$20,000 looks like little more than a convenience payment for a rubber stamp signature.

The situation on the inside of Cemtrex is no better. Cemtrex’s CFO is Renato Dela Rama. Presumably in this role, he would be responsible for coordinating the audit with Bharat Parikh, if one were actually being done.

But in 2015, Cemtrex reported in SEC filings (see below) that Dela Rama received zero compensation for this role in 2014 as well as in 2015. In fact, on his LinkedIn page Dela Rama does not even disclose that he even works for Cemtrex at all. Instead, he only lists that he is the controller for Ducon Technologies, which is run by Aron Govil.

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So, lets get this straight: Cemtrex’s CFO doesn’t even report that he is the CFO of Cemtrex and for the past several years, Cemtrex also discloses that he wasn’t even getting paid for that role.

In fact, he is actually getting paid by Aron Govil via Ducon. And Aron Govil is the guy who is using an undisclosed entity to pay notorious stock promoters to finance a touting campaign on Cemtrex.

Got it ?

In 2017, Cemtrex’s SEC disclosure suddenly contradicts its 2015 disclosure. The fact that a change was made is never noted and certainly not explained. Years after the fact, Cemtrex began claiming that it had actually paid Dela Rama $40,000 per year in each of those previous years.

In fact, the $40,000 number becomes even more troubling.

Even at $40,000 this is exceptionally low pay for a CFO of a supposed multinational conglomerate. It is also well below what he gets paid by Aron Govil at Ducon, where Dela Rama is not even CFO. No one would be expected to devote full time attention to a multinational company for just $40,000 per year, especially not in New York. My secretary in New York used to make over $60,000.

For reference, here we can see that average salaries for any full time CFO in the US was $315,947 as of December 2014 (about 8x what Dela Rama is supposedly being paid, if he is being paid at all).

And to be clear, over $1 million has been paid to notorious stock promoting firms to pump up the share price while only $15,000-$20,000 has been paid to supposedly “audit” the financials for the entire company. Meanwhile the CFO is only supposedly paid $40,000.

For the reasons above, I have precisely zero confidence in the financials being reported by Cemtrex. This will become especially clear below when we look at the spectacular performance which Cemtrex has reported immediately after acquiring obscure foreign companies which are revealed to be entirely insolvent just before being acquired by Cemtrex.

The Cemtrex financials signed off on by Bharat Parikh and CFO Dela Rama have now shown 20 straight quarters of apparent profitability and soaring revenues. This “success” has then been widely echoed and amplified by the aggressive stock promoters being paid by Aron Govil through an undisclosed entity. And this is exactly the formula which caused the stock to soar from below $2.00 to over $7.00 in 2016.

Point #4 – The 3rd party service providers

Whenever I come across another paid stock promotion, I always, always, ALWAYS know exactly what I will find next. Each of these companies relies on the same 3rd party service providers such as law firms, investment banks and “IR firms“. The world of small cap stock promotion is basically a small country club and all of these guys know each other.

With Cemtrex, we can see that the company has relied heavily upon Chardan Capital and Source Capital as its bankers. For IR, Cemtrex uses Irth Communications. Each of these firms will be detailed below. But it is safe to say that there is very notable overlap between the client lists of all three firms. They all work for many of the same firms and people. From there, we also see that they also service the exact same companies which have been heavily promoted by the exact same stock promoters, including SCS, listed above. In each case, these client companies have then repeatedly imploded or been halted or delisted, due to fraud.

This raises two issues:

First, if the last 20 or so companies represented by these third parties generally skyrocketed due to excessive promotions and then imploded, it seems like a safe assumption for any objective investor to suspect that Cemtrex might do the same thing. This is just common sense.

Second, when this pattern of shareholder destruction is so obvious with their client lists, why on Earth would any company ever select these 3rd parties to represent them (unless they simply had no alternatives, because they too were nothing more than a blatant stock promotion). Again, this is just common sense.

Source Capital and Cemtrex’s recent rights offering

Cemtrex relied upon Source Capital Group to run its recent rights offering which was completed a few weeks ago in January, raising $13 million.

In February, just days after the completion of Cemtrex’s rights offering, we saw the following headline:

Goodman & Nekvasil, P.A. won a FINRA arbitration award against Source Capital Group on Feb. 3 while working on behalf of three retirees, William B. Lashlee and Keith and Joyce A. McCrea. Lashlee is an 88-year-old retired native of St. Simons Island, Georgia, and the McCreas are a retired couple who live in Yorkville, Georgia.

Both groups alleged they were sold unregistered and unsuitable investments in IPG stock by Joseph Hooper, who was working as a representative. Lashlee invested $220,000 and the McCreas invested $590,000 for a combined total of $810,000 in IPG stock.

IPG quickly went bankrupt and Source was found to have been negligent.

As of last week (February 17th, 2017), we can see that Source Group had its FINRA registrations terminated in all states in which it was operating. FINRA notes that Source Group ceased business operations in February 2017.

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From Source’s website we can see that the firm has raised money for a number of other heavily promoted microcaps which then imploded. Like Chardan below, this includes a number of tiny Chinese reverse mergers which were delisted (but only after they raised substantial capital from US investors).

My regular readers will remember back when I previously exposed a massive stock promotion ring run by “The Dream Team Group“, which also operated under the name of Mission IR. Dream Team / Mission IR had recruited numerous authors to write extensive undisclosed paid promotions on dozens of micro cap stocks. These authors would pretend that they were industry experts or hedge fund managers and would write aggressive articles recommending the client stocks. These stocks then soared in price, allowing the companies and their management to sell stock at inflated prices. After my expose, each of the implicated companies ended up plummeting by as much as 95%, and a number of civil suits and SEC investigations ensued.

Dream Team / Mission IR were the architects behind a widespread ring of stock fraud and promotion. I even produced the internal documentation to prove it.

Here we can see that Mission IR lists Source Capital as its “conference partner“. Here we can also see Mission IR promoting Source Capital’s “Disruptive Growth Conference“.

Note that a number of the companies which attend Source’s investor conference also happen to be banked by Chardan and/or are clients of Irth Communications as well. These attendees of Source’s disruptive growth conference also happen to be heavily promoted by the same promoters listed above, including our favorite, SCS. This is easy to see by logging on to either Hotstocked.com or Stockpromoters.com.

At FINRA’s Broker Check website, we can also see where Source was fined by FINRA for having sold investments to investors “without disclosing material facts” and sold investments by making “exaggerated promises in multiple emails” as well as selling securities “at prices which were not fair“.

Either way, following the termination of its FINRA registration in all states, it appears that Source Capital is no more.

Chardan Capital Markets

Cemtrex retained banker Chardan Capital Markets to run its S3 offering in 2016. Cemtrex was then forced to withdraw the offering because Cemtrex did not meet the requirements as a result of failing to file required SEC documents .

Chardan and its management have a long history of run-ins with the SEC and FINRA. This includes various reports of manipulating small cap stocksinsider trading activity, failure to disclose various stock holdings and transactions as well as defrauding the US Small Business association out of $35 million. Chardan then launched into the Chinese Reverse Merger / SPAC game. Geoinvesting subsequently highlighted no less than 17 different examples of Chardan Chinese reverse mergers/SPACs, the majority of which completely imploded following exposure of or allegations of fraud.

Irth Communications – Cemtrex’s “IR” firm

Cemtrex’s IR firm is Irth Communications. As with Source Group above, Irth is listed as an IR partner of Mission IR (AKA the Dream Team Group) which was found to be behind a massive illegal stock promotion ring.

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As shown on its website, Irth has been responsible for various aggressive media placement campaigns for its clients, getting the stocks and their management strong favorable mentions in mainstream media outlets.

But as we can see below, many of these stocks are the same stocks that have been heavily promoted by the promoters listed above, including our favorite, SCS. These stocks have then eventually imploded despite tremendous positive coverage generated by Irth.

Many retail investors have been lured into buying Cemtrex stock solely as the result of seeing these high profile, positive media placements on Cemtrex which have been entirely arranged on their behalf.

As for the glowing media coverage that has suddenly exploded upon Cemtrex and the Govils, this is something that I have seen on many occasions.

For example, in January of 2011, China Media Express (formerly CCME) obtained the following headline from none less than Forbes:

China MediaExpress Holdings, Inc. Ranked #1 in Forbes China List of Small-to-Medium Sized Chinese Companies with the Greatest Potential

Just 60 days later, CCME was delisted when it was uncovered as an abject fraud. Thanks Forbes.

In the US, the micro cap Organovo shot up 3.5x from $4.00 to $14.00 following the publication of this article in Popular Science, which was a full feature on that microcap stock filled with hype and hyperbole.

How 3-D Printing Body Parts Will Revolutionize Medicine

Organovo subsequently fell from $14.00 to its current levels of $2-3 when it became apparent that the “3D printing of body parts” was pure fantasy. Thanks Pop Sci. In these cases above, there is certainly no evidence that this coverage was paid for. However, it has been my observation that anyone can obtain glowing media coverage if enough money is paid to a PR/IR/Media agency. Given that millions of dollars have already been paid to stock promoters, it should come as no surprise that aggressive media placements have proliferated covering Cemtrex and the Govils. Irth was founded by brothers Andrew and Robert Haag. The Haag Brothers had both previously worked for small cap investment bank Auerbach, Pollak & Richardson. Auerbach folded in 2001 after its securities registration was revoked following a variety of regulatory violations. In 2002, Andrew Haag then went to work as CFO and director of microcap reverse merger Quintek Technologies, a former Auerbach client. In 2002, Quintek’s CEO was sanctioned by the SEC for having put out a variety of false and misleading press releases regarding phony purchasing orders, causing the stock to soar dramatically, coincidently just as the company was looking to raise money. Haag stayed on with Quintek until 2008. He notes that as CFO, he “Raised $5 + million in capital, Increased Valuation + Liquidity, Expanded Shareholder Base 10 fold, Responsible for Cash Management, Responsible for Public Filings, Corporate Development”. But we can see that by 2008, the SEC was already hounding Quintek for putting out delayed financials which contained material inaccuracies (ie. Just like Cemtrex). These financials then needed to be publicly restated. As CFO, Hagg stated to the SEC that he would be retaining a PCAOB audit firm to rectify the inaccuracies in the financials. But instead, the members of management simply resigned and Quintek stopped making further SEC filings. Quintek just went dark leaving investors with nothing.

Following the implosion of Quintek, Haag and his brother then founded Hampton Growth Capital which focused on “Investor Relations” and “Capital Formation“. Like Chardan and Source above, Hampton placed a heavy focus on servicing Chinese reverse mergers, helping to promote them so that they could raise money from US investors. By 2011, following the wave of fraud among Chinese reverse mergers, Hampton’s Chinese reverse merger clients had been completely delisted. With Hampton in disgrace, the Haag brothers then ceased using that name began using a new name, “Irth Communications”, and promoting US based micro caps.

Below you can see the stock performances of some clients of Irth Communications. You can see that most of these have imploded by as much as 90% from their highs following the promotion.

For those who wish to check on their own, you can see that most of these Irth clients happen to also have been the subject of heavy paid promotion including via our favorite promoter group SCS. Checking this is easy by simply going back to Hotstocked.com or Stockpromoters.com.

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Point #5 – Financial and disclosure “irregularities” and inconsistencies

Given the state of Cemtrex’s auditors and bankers, seeing blatant errors, “irregularities” and inconsistencies should come as no surprise. But as I have shown repeatedly in past articles, when we see such repeated irregularities in a company’s SEC financials it generally presages an implosion in the share price and/or a delisting of the stock.

Again, here is a link to all of Cemtrex’s SEC filings.

Anyone who has performed a detailed review of Cemtrex’s SEC filings should know that Cemtrex tends to play very fast and loose with its SEC reporting requirements.

The filings that Cemtrex is required to make have been late, they have been inaccurate, there have been blatant inconsistencies between various filings that are never reconciled.

This includes even the most major filings such as the annual 10K and the Proxy. Cemtrex originally filed its previous 10K filing in December of 2015. Almost 9 months later, it was still filing amendments and corrections to correct blatant errors in that filing. The mistakes included very major items, such as the details of its liquidity position, as well as many minor items such as various spelling and grammatical mistakes which should never be found in a 10K.

The delayed and inaccurate filings are the reason why Cemtrex was forced to cancel its S3 equity offering in 2016, which was being run by Chardan Capital. Instead, Cemtrex was then forced to conduct a much more lenient rights offering, which would then be run by Source Capital Group. Rights Offerings can be completed even by those companies who become ineligible to do an S3 offering.

Because of this negligence / omission in SEC filings, Cemtrex was forced to disclose in the most recent 10K that:

We did not timely file with the SEC (NYSE:I) our definitive proxy statement, which includes the information required by Part III of Form 10-K, within 120 days of our fiscal year ended September 30, 2015, (ii) our Form 8-K in relation to our meeting of shareholders held on March 7, 2016, or (NASDAQ:IIIseveral other current reports filed during the preceding 12 calendar months. All of these reports were ultimately filed, but their lateness caused us to become ineligible to use Form S-3, a shorter registration statement that is often used for “shelf” registrations. If we are not able to file our current and periodic reports and other documents with the SEC in the future in the times specified by the Securities Exchange Act, we will continue to lose our eligibility to use Form S-3 for future capital raises, and that could impair our ability to conduct more efficient and expeditious public offerings of our stock off of shelf registrations. Our inability to timely file current and periodic reports in the future could materially and adversely affect our financial condition and results of operations.

Examples

As we saw above, Cemtrex originally disclosed that it pays its CFO nothing. Later on, it quietly revises this previous disclosure after the fact and without explanation. The new disclosure indicates that this CFO of a $100 million revenue multinational is paid a mere $40,000.

And then next we saw how the number of shares of each and every member of management has declined substantially over the past year (during a paid stock promotion), even though none of them filed a Form 4 to disclose any sales.

So now let’s explore the issue of possible backdating of option grants by Saagar Govil, just before the paid stock promotion campaign really took off.

As we saw above, the bulk of the promoting campaign began in March of 2016.

In the 10Q released in May of 2016 Cemtrex discloses that:

On February 12, 2016, the Company granted a stock option to purchase 200,000 shares of Common Stock to Saagar Govil, the Company’s Chairman, Chief Executive Officer, President and Secretary. These options have an exercise price of $1.70 per share and expire after six years.

So, apparently by pure coincidence Saagar Govil happened to award himself 200,000 shares worth of options on the exact day of the exact lowest closing share price over the past two years ! So either Mr. Govil was preposterously lucky or else this looks a lot like options back dating. As we know, options backdating is quite illegal, as noted here:

Because publicly traded corporations must properly report the value of options on their financial statements, any backdating could result in a misstatement that can be the basis for a charge of securities fraud.

This becomes more of an issue when we look at the quarterly financials that Cemtrex filed with the SEC AFTER Feb 12, 2016.

In that 10Q filed in May of 2016 (3 months AFTER the options had supposedly been awarded), Cemtrex disclosed no change in “Share Based Compensation” for the quarter despite the 200,000 options which had supposedly been granted to Govil in February. By the time that quarter was reported, the share price had already risen by around 30%.

Upon receiving that options grant, Saagar would have been required to disclose it on Form 4. However, no Form 4’s were filed in all of 2016.

The second grant to Govil is just as curious. In the most recent 10Q filed with the SEC in February 2017, Cemtrex disclosed that it had awarded another 200,000 shares of options to Saagar Govil. It had noted that the options were granted on December 5th 2016, at a price of $4.25 per share.

Looking back from February 14th, 2017, we can see that again the week of December 5th again corresponded to the lowest closes for the stock over the preceding 3 months. Once again, Mr. Govil had impeccable timing.

What gets really curious again is the fact that when Cemtrex released the 10K on December 28th (i.e. AFTER the supposed options grant had already been given) the company only disclosed the earlier 2016 option grant and not the new one, supposedly made on December 5th. Again in January 2017, Cemtrex released its Proxy Statement. And again, the company only disclosed the earlier February stock grant to Govil. No mention was made of the December 5th options grant.

And just as in the past, Saagar Govil never filed the REQUIRED Form 4 to disclose the new shares given to him.

In January, the stock really took off. By the time Cemtrex disclosed the new options grant to Govil, the share price had repeatedly broke through new highs north of $7.00 and had briefly exceeded $8.00, such that backdating the options just before releasing the 10Q could have resulted in as much as $800,000 in instant profits for Saagar.

These discrepancies are particularly notable given what we have seen with the auditor and the CFO.

Cemtrex directors

Separately, we can also see that Cemtrex’s outside board members consist of Shamik Shah and Sunny Patel. Both of these individuals are young hedge fund traders who focus on trading stocks, futures and/or derivatives. They show no experience in anything related to running a public company, engineering or environmental controls or accounting issues. They have no business being directors of Cemtrex, aside from potentially around issues regarding trading the stock.

Just like Saagar Govil, we can see that 30 year old Shamik Shah went to school in New York and graduated with his undergrad degree at exactly the same time as Saagr Govil in 2008.

Diretor Sunny Patel is also now 30 years old also graduated from the same school in New York in 2008 and also worked as a derivatives trader with a hedge fund.

Just like Saagar Govil, these two were brought on as directors for Cemtrex despite having no relevant work experience.

Both Shah and Patel were appointed as directors in April and May of 2015. That happened to be precisely when Cemtrex was applying to uplist from the OTC BB to the NASDAQ. As part of that process, the company is required to have outside board members, which is why Cemtrex appointed these two then 28 year olds with no relevant experience those roles. By fulfilling this simple requirement, Cemtrex was then able to uplist to the NASDAQ just a few weeks later.

Either way, as directors of a public company, these individuals are presumably now fully on the hook for any potential issues which may arise from any potential undisclosed paid stock promotion, auditor misrepresentations and/or selection issues, financial statement irregularities, back dating of options and etc.

HERE IS THE CONCLUSION !!

Based on the information laid out above, I believe the following:

I believe that it is highly likely that Cemtrex will face delisting and go to effectively zero.

Cemtrex management is paying for an undisclosed stock promotion via an undisclosed entity called Southern Steel & Construction. Aron Govil is behind Southern Steel & Construction, and that entity reports the same address as Cemtrex.

The promoters being paid include SCS, whose past promotions have imploded, been halted or delisted, including due to fraud.

During this undisclosed paid promotion, the Govil’s have actively encouraged investors to buy Cemtrex shares via social media. At the same time, members of management have been making large sales of stock without disclosing those sales on Form 4 as required by the SEC.

Cemtrex’s auditor (Bharat Parikh & Assoc.) is actually controlled by an individual (Mahesh Thakkar) who has been banned by the SEC and PCAOB as a result of multiple past audits, sign off’s or reviews which were fraudulent. Cemtrex’s auditor continues to report to the SEC that it is running its operations out of 4940 McDermott Rd., Plano, TX. Yet that location is actually a completely vacant strip mall. The phone number has been disconnected. According to Texas State records, the auditor is not even licensed to practice in Texas. Thakkar has run multiple different audit operations out of 4940 McDermott under various different names (including Thakkar CPA, The Hall Group CPA, TMK LP and now Bharat Parikh). Each one of the previous ones has been shut down. Thakkar then changes the name of the firm and keeps auditing the same clients, all from the same vacant address.

Cemtrex claims to generate nearly $100 million in revenues from subsidiaries across 4 countries and 3 continents. Such a company would normally expect $500,000-$1 million in audit fees per year. Yet Cemtrex pays Bharat Parikh a mere $15,000-$20,000 per year.

Cemtrex’s 3rd party service providers include Source Capital, Chardan Capital and Irth Communications. Each of these parties has a long and noticeable history of doing business with small cap stock promotions which have been promoted by SCS or the other promoters behind Cemtrex. There have also been past involvements with companies, individuals or activities with have involved imploded stock promotions or securities fraud.

Cemtrex’s filings repeatedly contain information which is either inaccurate or inconsistent between filings. Many filings comes extremely late. Many required filings have not come at all. It is clear that shares owned by members of management have declined substantially during the course of the paid promotion. Yet no Form 4’s have been filed to disclose sales to investors or the SEC. Past disclosure states that the CFO was working for years at zero salary from Cemtrex, while he was being paid by Aron Govil’s Ducon. Option grants to Saagar Govil occurred at times when the share price was hitting deep lows. These grants were not disclosed until after the share price had appreciated substantially. Earlier filings, which should have disclosed the impact of those new shares under the option grant, made no mention of the options until much later, after the share price had already risen.

Again, to me the case for fraud and delisting seems obvious.

Appendix A – past frauds or promotions by SCS which were halted, delisted or imploded

SCS clearly matches the exact type of promoter that the SEC is warning us about in terms of “microcap fraud” because numerous promotions from SCS end up getting quickly halted or delisted by the SEC. Examples of halted or delisted stocks from SCS have included:

– Code Rebel (formerly CDRB)

– Forcefield Energy (formerly FNRG)

– Grow Life

– Fusion Pharm

– Petrotech Oil and Gas

– Among others…

Just like Cemtrex, each of these stocks surged by hundreds of percent following aggressive promotion campaigns by SCS promoters. Just like Cemtrex, each of these stock promotions had a very well crafted investment story specifically designed to lure in retail investors.

Each of these stocks were then halted or delisted outright when the SEC found financial irregularities or outright fraud.

So again, these are the exact promoters that Aron Govil is paying using an undisclosed entity in New York.

Both Hotstocked.com and Stockpromoters.com continue to list the paid promotions of these stocks which were run by SCS.

Just like Cemtrex, Code Rebel was being promoted by SCS as an acquisition play. Paid promotion and press releases around the acquisition hype caused the stock to surge by several hundred percent shortly before it was delisted and went to zero.

Just days after the latest SCS promotion, The SEC noted that it had suspended trading in Code Rebel:

because of questions regarding the accuracy of statements in CDRB’s Forms 10-Q for the quarters ended June 30, 2015 and September 30, 2015, and the Form 10-K for the year ending December31,2015, concerning the company’s assets and financial condition. This order was entered pursuant to Section 12(k) of the Securities Exchange Act of 1934 (Exchange Act).

Similar promotion efforts by SCS caused Forcefield Energy to soar by hundreds of percent. In the case of Forcefield, the stock quickly fell by 60% immediately after my own article exposing the fraud. In fact, within just a few days of my article exposing the fraud, the stock was halted by the SEC and then delisted. It was a zero within just days.

At the time, the SEC noted that it was suspending trading at Forcefield:

due to concerns about the adequacy and accuracy of information available to investors concerning the funding of recent articles and promotions touting FNRG, including for example in articles published on December 9, 2014 and February 26, 2015. Questions have also arisen concerning potential manipulative activity of FNRG’s stock, including transactions between February 25 and April 2, 2015 and the funding of those transactions. This order was entered pursuant to Section 12(k) of the Securities Exchange Act of 1934 (Exchange Act).

For reference, here is my previous article on Forcefield, which I published when the stock was at $7.50 – just a few days before that suspension from the SEC.

Appendix B – Additional Cemtrex promotions

Here is a partial screenshot showing just a few of the recent promotions, click the links above to see dozens and dozens more. I encourage interested readers to go to Hotstocked.com or Stockpromoters.com to read more examples.

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These sites show that the promoters and payors behind Cemtrex include:

– Broad Street Alerts, Small Cap IR, and Small Cap Street (under the umbrella of Small Cap Specialists (“SCS”)

– Third Coast Media

– TSX Ventures

– Stock Market Leader

– Micro Cap Research

– Small Cap Leader

– Southern Steel & Construction

Despite the warnings from the SEC, there seems to be a never-ending stream of new retail investors who continue to fall for the well-constructed schemes of stock promoters. And aside from those stocks that have been halted and delisted, these promoters have been behind dozens of additional stock schemes which simply imploded to the pennies without ever being formally halted or delisted.

Appendix C – Looking at the short interest

The Govil’s have repeatedly made it a point to blame “the shorts” for any weakness in the share price and for any criticism that comes to their company or management. This is a very common diversionary tactic with stock promotions. Unfortunately, many naïve retail investors continue to fall for it.

But with Cemtrex, the math simply doesn’t add up. As of January 31st, there were only around 400,000 shares sold short, amounting to just over $2 million in total. This is virtually nothing. Cemtrex typically trades around 500,000 shares every day.

The short interest has also been steady at 100,000-400,000 shares for the past 6 months, such that there has been very little increase relative to the volume. Every share sold short could easily be covered within 1-2 trading days while having minimal impact on the share price. Likewise, the entire short interest of 400,000 shares would have minimal effect of Cemtrex’s share price over this time.

Here is the link to the NASDAQ showing short interest as well as a screen shot for your convenience. Note that the “days to cover” indicates that the entire short interest could be covered in a single day’s trading.

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SCS’s promotion of fraudulent Forcefiled Energy was just the same. Despite a very low short interest, Forcefield tried to distract retail investors by blaming its problems on evil short sellers. But this diversionary tactic from management didn’t slow the immediate 60% plunge in the share price of Forcefield. Clearly inside share holders were the ones selling big even as they were trying to persuade retail shareholders not to sell or to even buy more. But this would only be revealed once the subsequent criminal indictments came out against Forcefield Management.

For your reference, here is a press release put out by Forcefield Energy just after my article in which the Chairman accuses “the shorts” of disseminating false and misleading information. He also claims that he was initiating a regulatory investigation with the SEC to supposedly pursue “the shorts” in defense of his shareholders.

Instead, the Chairman was doing no such thing. Right as he was issuing press releases to reassure retail holders, he was actually in the process of attempting to flee the country while he was simultaneously dumping his shares. Within just days, he was arrested by the FBI as he attempted to board a flight to Central America. Forcefield’s stock was halted, going quickly to zero. The Justice Department later announced that 9 individuals were arrested and indicted on massive securities fraud charges behind the promotion of Forcefield.

I have frequently come across many similar examples of stock promotions who try to distract retail investors by diverting attention to “the shorts”. They all typically tend to end the exact same way (with a trading halt, a delisting or a simply share price implosion).

Yirendai ($YRD): Leaked Internal Emails Raise Much Deeper Concerns

Summary

  • Shares of YRD have been shunned by traditional China smart money. Outside ownership is dominated by a few US “quant funds” who perform little fundamental research.
  • Existing concerns have weighed on the stock including fraud, an explosion of guaranteed subprime credit exposure and new illegal activities in China.
  • To entice lenders, YRD guarantees deep subprime loans. But YRD’s risk reserve is deeply under capitalized while deep subprime exposure now exceeds 80%.
  • An unnamed fund affiliated with Chairman quickly dumped nearly all of its YRD shares following the new PRC guidance which made such guarantees illegal.
  • Recently leaked internal emails show that YRD’s Chairman is forcing parent company employees to make undisclosed USD purchases or be fired.

Note #1: Everything in this article represents solely the opinion of the author. Nothing herein comprises a recommendation to buy or sell any security. Information in this post has been obtained from sources believed to be reliable, including SEC filings from the company named. As always, readers should conduct their own research and form their own opinions and conclusions.

Note #2: Prior to publication, the author shared information and documents from below in a written report to the United States Securities and Exchange Commission.

Company Overview

Name: Yirendai (NYSE:YRD)

Industry: China P2P lending / finance portal

Market cap: $1.3 billion

Share price: $20

52 week low: $3.35

Options: Liquid calls and puts

Short Thesis:

– Deep subprime overexposure

– Surge in loan fraud

– Undisclosed illegal activities risk in China

– Stock price irregularities / trading activity in the US ADR’s

– Predatory related party transactions benefiting parent company over US investors

PART A: INDUSTRY PREVIEW – P2P IN CHINA IS COMING UNRAVELED (YOU SHOULD HAVE KNOWN BETTER)

In just the last few days, US investors have begun to find out what Chinese investors have known all along. This information comes from two articles last week in the Wall Street Journal and the English language South China Morning Post over the past few days.

As I will show, the problems facing China’s P2P lending space are transparently awful. Investing in this space defies commons sense. But as I will show later, the problems specific to YRD are actually even worsethan the generic problems of the industry as a whole.

Just from a macro common sense perspective it is safe to say this: anyone dumb enough to be LONG on stocks with heavy exposure to China’s domestic credit markets should probably not be managing money. Evidence of China’s “default storm” is said to already be exacerbating a “recent spate of fraud” in the credit markets “amid a rout that has analysts predicting a record number of defaults in 2017″. Just look to Bloomberg, the WSJ, the New York Times, or any English language financial news journal covering China.

For the most part, larger US investors (and effectively ALL Chinese investors) have shunned YRDs ADRs. In terms of outside investors, only a few smaller “quant funds” continue to hold positions. These investors make their investment decisions based on “factor models” which focus on key headline metrics and NOT based on underlying fundamental research into the company.

The P2P lending space in China is something akin to a Ponzi scheme which is rife with fraud. This is NOT an overstatement.

This is why China investors have shunned the space and why Chinese securities regulators have made P2P IPOs so difficult to achieve in China. The regulators in China seek to protect Chinese investors. So instead, these P2P players from China are simply choosing to IPO in the US where various smaller investors can be lured into the stock.

YRD initially intended to raise $300 million in its NYSE IPO. A few months later, the IPO was only able to raise $75 million at $10. And then, even that tiny IPO traded down as much as 16.5% on the day of the IPO.

Seemingly nobody wanted to buy YRD at any price. Within months, the stock traded down to as low as $3.35 in 2016. In the IPO and the aftermarket, YRD has been unable to sustain any substantial investment from any major institutions and certainly no smart China money has shown any interest whatsoever in owning the stock.

During 2016, YRD continued to report loan growth which was downright explosive. (But so did every other P2P player in China’s rapidly booming P2P space). Accordingly, the headline metrics for YRD looked temptingly good. YRD appeared to present a low P/E ratio, strong revenue growth, huge return on equity, etc. This began to attract a number of US quant funds (shown below) to take numerous small positions based on their “factor models”.

Here’s where it gets interesting.

At the time of the lows, YRD stock was also supported by undisclosed buying by an unnamed fund affiliated with YRD Chairman Ning Tang. (Even as no major institutions and certainly no major China investorshave shown any willingness to own the stock at any price.) The purchases by this unnamed Fund would not be disclosed until 6 months later, and in fact the purchases themselves would not even be disclosed until well AFTER the Fund had already dumped its shares.

As a result of the quant momentum buying and the purchases by the undisclosed Fund, at one point, shares of YRD had risen by more than 10x from those lows. But they have now begun to falter, Shares of YRD are now down by around 50% from those highs reached a few months ago, even as loan growth continues to soar and presumably YRD’s apparent “profits” continue to get “better and better”. Over the past few weeks, the share price can’t seem to catch a bid from anywhere. Notably, the unnamed Fund has already dumped nearly ALL of its shares at higher prices.

However, to keep this in perspective, even at $20 the shares are still up dramatically from the $3 lows in 2016.

As I will show below, China’s securities regulators have deliberately made it much tougher for P2P players to IPO in China. They are seeking to protect Chinese investors. As a result, these P2P players simply turn to the US capital markets to raise money via IPOs.

Just last week, it was revealed by the English language South China Morning Post that Chinese P2P lender Ppdai.com would also choose to come public in the US. Like YRD, Ppdai’s expectations are ambitious and it hopes to raise $200 million from US investors. Additional players in the China P2P space such as Dianrong and China Rapid Finance are also expected to tap the capital markets.

Ahead of the Ppdai IPO, the SCMP article quite clearly comes across as a warning to US investors who might be tempted to invest in a Chinese P2P. The SCMP makes clear what Chinese investors have known all along. Here are a few quotes from SCMP, which again came out just last week:

– In China, “P2P lending…has been mired in a slew of scandals amid runaway investment and fraud since late 2015.”

– “Beijing will heighten requirements for P2P players…The intention of the heightened regulation is partly to shut down some firms that purport to be P2P lenders.”

– “dozens of unscrupulous players raised funds from depositors and then channeled the loans to corporate clients such as property developers.”

– “In 2015, Beijing-based Ezubao was found to have defrauded more than 1 million investors of about 100 billion yuan.”

The SCMP article came out last Monday. By Friday, we had a separate article from the Wall Street Journal which should serve to further warn US investors about the P2P space in China.

A Default in China Spreads Anxiety Among Investors

The firm highlighted by the WSJ is Cosun, a Chinese phone maker. Unlike the loans facilitated by YRD (which are effectively consumer to consumer), this was a corporate that had raised the money via P2P.

And the firm that facilitated the loans was Ant Financial, which is owned by giant Alibaba Group (NYSE:BABA). In other words, we are NOT talking about a small time player here. The problems in China’s P2P space have infected every corner of that market.

According to the WSJ, the investment process here is effectively the same as the process used by YRD and every other China P2P player.

A large number of small Chinese retail investors (in this case it was around 13,000 investors) log on with their smart phones and opt to make small investments in some sort of P2P loan product. There is no researchand no due diligence. They just click on their smart phone and then “poof” they have invested in something which is supposed to provide some attractive level of returns. Their money is transferred out of their bank account immediately and automatically.

As shown by the WSJ, the default

illustrates a rising risk in China, where hundreds of millions of people seeking higher returns on their savings have used their mobile phones to buy risky, unregulated investments.

Again, the P2P in this case was backed by China’s Alibaba, perhaps the largest and most prestigious name in Chinese ADR’s. YRD is certainly in a far lower league than Ant and Alibaba. At its lows last year, YRD was worth just $200 million.

And (just like we will see with YRD), the Cosun case looks like it demonstrates a clear example of outright fraud being the culprit. Notably, both Chinese and US investors have been victimized.

From the WSJ:

Other businesses owned by Cosun’s founder have faced accusations from U.S. and Hong Kong securities regulators that they engaged in dubious accounting. Three of his companies got delisted from stock markets in the U.S. and Hong Kong. He appears to have never responded to any of the claims.

It sounds like investors should have known better. But with no research being conducted during their quick smart phone process, this is what happens.

THE POINT:

The point of this so far: Investing in China’s P2P space is just downright dumb. You have already been explicitly warned by the SCMP and the WSJ. Chinese equity investors and regulators have known this all along. This is why the P2P players are dumping these ADR’s on US investors.

As we will see, the specifics as they apply to YRD are even worse.

PART B: SUMMARY OF YRD SPECIFICALLY

I have spent much of my adult life living, working and traveling in China. I studied Chinese at Peking University, which the Chinese often refer to as the “Harvard of China”. When in China, I spend most of my time in Beijing and I have often invested long and short in US listed Chinese stocks following my career as an investment banker in Hong Kong and New York.

There are certainly a few interesting US listed Chinese ADR picks. But as I’m going to show today, Chinese P2P lender Yirendai is actually a compelling short.

The last two problematic Chinese ADR’s I exposed fell by 50-90%.

Additional Chinese stocks I have exposed were subsequently delisted or became the subject of SEC investigations.

To fully understand the depth of the problems at YRD, there are a wide variety of points to be made. Some are very severe and urgent. Some are more along the level of just disturbing trends which are sharply worsening over time. For the sake of completeness, I am going to address all of these points and let the reader figure out which ones mean the most to them according to their own perspective.

PLEASE NOTE:

TO UNDERSTAND HOW EACH OF THESE PIECES FIT TOGETHER, IT IS IMPORTANT TO READ THIS ENTIRE ARTICLE. THE POINTS I MAKE ARE DELIBERATELY PRESENTED IN ORDER OF INCREASING SEVERITY.

At the end of this article, I will show an internal email from YRD’s Chairman Ning Tang to his employees at YRD parent Credit Ease which were posted on a site in China. According to those postings, effectively he is requiring employees to contribute their own personal money (required to be made in US dollars) into a fund which is buying “undisclosed” US equities (presumably shares of YRD). The order from Ning Tang is mandatory and he makes it clear that anyone who doesn’t personally buy into this is threatened with immediate dismissal. Yeah, it’s that bad.

I will also show how an undisclosed and unnamed “affiliated fund” of Ning Tang was aggressively buying shares of YRD at the lows last year, but then dumped effectively all of its shares right as new regulations loan guarantees (such as those by YRD) are in fact illegal. That fund dumped at prices well above current levels.

As a preview, here are the points which will be elaborated and substantiated below:

  • None of the usual China “smart money” (i.e. funds like Sequoia, Matrix, etc. ) are willing to invest anything in YRD. YRD’s Chairman still owns a large indirect stake in YRD, but other members of YRD management refuse to own any shares whatsoever. As I will show below, the reasons for this will become blatantly obvious.
  • Outside holders are primarily US based low fee quant funds who have made their investment selections based on superficial analysis of basic equity metrics such as stated “EPS growth”, stated “book value” and stated “gross profitability”.
  • These metrics, which appear to be positive on the surface, are only made possible by virtue of YRD providing a credit guarantee (which has recently been deemed illegal in China). Investors are clearly not pricing in the now extreme subprime credit risk. They have also not appreciated what will happen to YRD’s metrics when the now-illegal credit guaranteedisappears (which it is about to).
  • US listed YRD was actually spun out of parent company Credit Ease. Credit Ease originates fully 67% of YRD’s loans and takes a flat cut out as an origination fee. Credit Ease therefore receives substantial income with zero risk. By virtue of the guarantee, US investors in YRD bear all of the risk associated with the loans. It is a massive related party transaction which benefits the parent company over US shareholders.
  • YRD maintains the loans for the P2P investors. Because YRD guarantees the loans, Chinese retail investors (P2P lenders) accept a very low rate of return and YRD enjoys very high income (in the short term) while loan growth continues to be strong (in the short term).
  • YRD (the entity sold to US investors) is actually a dumping ground for deep subprime loans for parent Credit Ease. As a result, YRD has dramatically altered its business model. YRD has gone from making mostly prime “A Grade” loans in 2013 to almost exclusivelymaking deep subprime “D Grade” loans with APRs up to 40%. Default rates for C and D loans are already soaring by far more than expected. But (even more troubling) even the “prime” “Grade A” charge off rates have skyrocketed from 2% to 9%.
  • Given the level of distress in “A Grade” loans, we can assume the “D Grade” loans are going to be exponentially worse. And deep subprime “D Grade” loans now compriseover 80% of new loans !
  • In reporting “delinquent loans”, YRD cherry picks the 15-89 day past due metric which it cites as just 1.9%. But this is largely irrelevant since the defaults tend to occur after 89 days, as we can see. Defaults beyond 90 days can be seen to be clearly much higher. (YRD’s highlighted metrics can therefore be filed under #AlternativeFacts)
  • YRD pretends to have its own sophisticated credit scoring system. But the reality is that there is no national FICO system in China. YRD approves loans to deep subprime “D Grade” credits within just 10 minutes with minimal credit checks in an application process completed on a smart phone. YRD allows borrowers to “self declare” their use of proceeds.
  • In the past two quarters, YRD was forced to disclose the impact of significant “organized loan fraud” affecting already approved borrowers totaling over RMB81 million. After their initial discovery, these fraud amounts were larger than originally assumed and YRD was forced to write off 100% of the amounts in question.
  • In addition, the only “risk reserve fund” established to back these loans is deeply undercapitalized.
  • But it gets better. These loan guarantees made by YRD for P2P loans have been made illegal under new regulations in China. Despite the new ruling, YRD continues to offer guarantees, simply because it must. I do NOT expect to see YRD get hit by any massive penalties in China in connection with illegal loan guarantees. Instead, YRD will simply be forced to stop offering the guarantee.
  • But without such a guarantee, YRD will be forced to give investors a dramatically higher payout, crushing its heretofore attractive “metrics” of both profitability AND growth. The US based quant guys who own YRD ADRs clearly haven’t figured this out. (…yet.)
  • The new regulations also prohibit ties to asset management activities. Yet YRD is clearly tied to asset management firm Toumi. In fact, I will reveal leaked internal emails below which show that YRD’s Chairman is forcing employees of YRD’s parent to personally invest their own money, SPECIFICALLY IN US DOLLARS into the Toumi asset management platform be for the purpose of driving money into some unnamed US dollar stock. Employees who don’t comply and contribute their personal money to this investment scheme will be fired ! (Note that the only US dollar stock connected to the Chairman happens to be YRD).
  • Prior to the compulsory Toumi investment, I will also show how an unnamed fundaffiliated with Chairman Ning Tang was aggressively making undisclosed purchases of YRD ADRs last year, pushing up the share price when it was struggling. The fund then immediately began dumping effectively all of its shares of YRD just as the government announcement about illegal loan guarantees came out. No disclosure of the purchases was made until after the shares had already been dumped.

PART C: BACKGROUND

Following my exposé of Chinese advertising company Air Media (NASDAQ:AMCN) that stock ended up falling by around 50%. Air Media had touted that it was being bought up by an outside 3rd party, causing the stock to more than double. The suckers were largely US investors who didn’t do their research in Chinese.

But once I posted the Chinese language documents online (along with English translations), we could see that the transaction was just a sham. The stock returned to its pre-hype lows.

But that one was pretty easy.

Other China trades were actually a lot more interesting.

In the past I had highlighted a US listed Chinese ADR called Sungy Mobile (NASDAQ:GOMO), which then fell by as much as 90%.

Sungy came public at a price of $11.22. It then quickly soared to around $30, giving it a market cap of well over $1 billion. The underwriter on Sungy’s IPO was Credit Suisse, who continued to tout the stock with a $34 target. The company lacked much by way of current financial results, but CS was predicting transformative growth which would presumably justify the lofty valuation.

When I first raised the alarm on Sungy, the stock was still sitting at around $28. I illustrated clearly that Sungy’s underlying “product” was not in any way commercially viable. The “product” consisted of various app downloads for one’s phone such as ways to customize the background wallpaper. Yes, it was really that bad. Sungy also had document reader app, which primarily competed with free offerings from software providers. Again, it was a pretty much nonsense of a product and it seemed hard to believe that anyone would fall for it. But there were a few buyers of the stock following the IPO. Ongoing support from the sell side and macro bullishness towards China elevated the stock price to irrational levels. In hindsight, it was obvious. (But then again, it is always obvious in hindsight….)

Following my article, Sungy began a rapid and steady downward trajectory, quickly hitting $12. The implosion picked up speed when each new deeply disappointing quarter showed that failure was inevitable.

The decline picked up even more speed and soon Sungy was down to $2-3. At this time, Sungy management simply took the company private, buying back all of the shares at around $5. It was quite a nice scam. Sell the shares to US investors at $11.22 and then buy them all back a $5 a little while later, keeping all of the cash and the remains of the businesses.

As we can see, Sungy isn’t the only Chinese company to foist a bad businesses upon unsuspecting US investors.

PART D: OVERVIEW ON YRD’S P2P LENDING ACTIVITIES

Yirendai (“YRD”) is a Chinese P2P lender, analogous to Lending Club (NYSE:LC) in the US.

Like YRD, Lending Club initially saw its day in the sun as investors flocked to the novel idea of P2P lending. But then a series of shady activities by management (originating undisclosed loans to employees to boost volume) along with revelations of very bad risk management sent the stock down by around 80% from $25.00 to around $5.00.

This is exactly what we will see with YRD. Keep in mind that loan volume has continued to grow strongly at Lending Club, just like it has at YRD. But apparently originating more and more bad loans is not something that ultimately supports a strong share price.

It did not take long for Lending Club to fall by 80%.

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Like Lending Club, YRD simply acts as a middle man. YRD connects willing retail investors (lenders) in China to willing borrowers in China. The lenders make loans to the borrowers via YRD’s platform and YRD sits in the middle and collects a spread.

In China, the growth of P2P lending continues at a torrid pace as small loan investors (lenders) continue to seek decent returns on small amounts of cash while consumers have shown they will continue to pay APR’s of up to 40% to take on loans which are becoming well beyond their financial means. In many cases, these the purpose of these loans is just to pay for consumer luxuries like cosmetic surgery or expensive vacations.

Along with the boom in P2P in China, there are a number of emerging concerns about the industry.

Keep in mind that such easy credit was not available in China during the global credit implosion of 2008-2009. Much of the reason that China stayed strong and stable following that US led crisis was that Chinese consumers had very little debt and lots of cash.

This arrival of unchecked easy credit in China is a new phenomenon which has largely been ushered in by P2P lending.

In August of 2016, Guo Guangchang, Chairman of Fosun International, told Bloomberg News that China’s peer-to-peer lending industry is “basically a scam,” arguing that players in the multi-billion dollar sector, troubled by collapses and frauds, lack the ability to price risk.”

In December 2015, the country’s biggest Ponzi scheme was exposed after Internet lender Ezubo allegedly defrauded more than 900,000 people out of the equivalent of $7.6 billion. China has 1,778 “problematic” online lenders, according to the banking regulator.”

And the stories continue to get more bizarre. Even last month (December 2016), Chinese regulators continued to raise concerns about other P2P abuses such as lenders requiring young girls to send naked “selfies” of themselves in order to receive P2P loans. Once they obtained the naked photos, the lenders then extorted the young women, threatening to publish the photos online.

The picture that quickly emerges of China’s P2P industry is one of a financial “wild west” which lacks sufficient regulations, controls and protections. In the absence of appropriate regulations, some P2P lenders have shown explosive growth via the use of deeply reckless practices.

(Think back to 2007 in the US when anyone involved in the mortgage industry was making a fortune by signing up volumes of new borrowers who clearly had zero ability to repay what they were borrowing.)

And now the situation in China P2P is actually changing, both from the industry side and from the side of the capital markets.

On the capital markets side, we can see from October 2016 that P2P players who want to go public are now less able to do so in China. They are being forced to sell their shares into foreign markets rather than to Chinese investors:

Due to regulators issuing stricter rules on online lending in October, A-shares are no longer considered favorable for P2P IPOs, likely driving P2P companies to list overseas.

In other words, because China’s regulators have determined that P2P companies are not suitable for Chinese investors, these companies are simply turning around and selling shares to US investors.

Keep in mind that over the past few years, many US listed Chinese companies actually took their companies private, LEAVING the US capital markets to get a much higher valuation by listing in China. But for the problematic companies that can’t list in China, deep pocketed US investors remain as a viable alternative. Valuation is simply not relevant. Completing the IPO at any price is all that matters.

As we will see, this is one clear reason why we see none of the usual “China Smart Money” involved in YRD. It also likely explains why we do not see any ownership by YRD management outside of founder Ning Tang’s legacy position.

This will be illustrated more clearly below.

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PART E: WHO DOES OWN SHARES OF YRD ? WHO DOESN’T OWN SHARES OF YRD ?

Both of the questions above are equally important.

First, let’s look at insiders.

From YRD’s 20F, filed in April 2016. We can see founder and Chairman Ning Tang owns 40.2% of YRD. This stake is owned indirectly because the shares are actually owned by Credit Ease, which is YRD’s parent company. Ning Tang is founder, Chairman and CEO of Credit Ease and via that ownership, he indirectly owns the shares of YRD. Ning Tang does not directly own any shares of YRD.

As described in a section below, Tang’s ownership then increased and decreased slightly as an “affiliated Fund” bought shares and then later sold them.

As we can see, from the 20F filed in 2016, no other member of management is willing to own shares in YRD.

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Each of Ning Tang, Huan Chen, Tina Ju and Yihan Fang hold significant roles as either executives or directors at parent Credit Ease. But as shown above, NONE of them aside from Ning Tang are willing to own shares in YRD.

Next, let’s compare YRD’s shareholders to what we normally see with the higher quality Chinese ADR’s listed in the US. Obviously what we are looking for is the presence of the “China Smart Money”.

As I have demonstrated clearly in the past, US investors who play US listed Chinese ADR’s often have very little idea about what they are investing in. The “safe way” to play the Chinese ADR’s is to invest alongside the “Chinese Smart Money”. By this I refer to a small group of China based that always seem to have perfect timing and much better information than everyone else. They make much more money than anyone else and they often act in the same way at the same time.

At the top of that list we usually find Sequoia Capital. When US listed Chinese companies were going private in record numbers in the past, Barron’s suggested that the smart way to play China was just to follow what Sequoia was doing, noting:

The venture capital owns 16.1% of cosmetics e-commerce Jumei (NYSE:JMEI), 14.6% of wealth management service provider Noah Wealth (NYSE:NOAH), 10.7% of China’s Craigslist 500.com (NYSE:WBAI), 7.5% of online travel agent Tuniu (NASDAQ:TOUR), 4.9% of mobile social media (mostly for dating) Momo (NASDAQ:MOMO) and 4.2% of Ski-mobi (NASDAQ:MOBI), a mobile app organizer.

The other “usual suspects” in China, such as Matrix, IDG, Shunwei and CITIC are also present in many of the most notable Chinese ADR’s.

So what do we see in YRD ?

Here is the most recent list of top outside investors in YRD.

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Here are the things that should stick out to you.

#1 – Precisely none of the usual “China Smart Money” have any interest in owning YRD. That’s a bad sign for YRD. Ordinarily one would expect to see several of the top China funds invested in such a US listed China ADR.

#2 – There are no funds whatsoever that have taken any substantial portion of YRD (i.e. absolutely no outside 5% holders)

#3 – No fund listed has a significant portion of their fund invested in YRD

#4 – The few funds that do hold positions in YRD are clearly “quant funds

Items #1-#3 above speak for themselves. No one in China or outside of China has been attracted to make any significant investment in YRD in meaningful size.

But item #4 (the involvement of quant funds) requires a closer look.

The list above shows that the largest investors in YRD includes: AJO, Numeric Investors, Acadian and Nepsis. As can be seen from each of their websites, these are clearly “quant funds”.

For example, on its website, AJO notes that:

Because the market is complex, opportunities are best exploited with a systematic, quantitative approach. We use modern investment technology and academic research to complement the wisdom of classical investment thinking and analysis.

AJO manages around $24 billion and typically chargesfeesof just 30-60 basis points.

My point (as I see it) is that quant funds tend to be diversified investors which charge low fees. As a result, they cannot afford to do deep research on each of the names they invest in. This is why they have no idea about the problems that I am unveiling today.

Here we can see the various “factors” that have likely led this type of quant fund to invest in something like YRD. The following comes from AJOs website.

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Looking at the “factors” above, it now becomes clear why a presumably smart quant fund like AJO would invest in something as awful as YRD.

Yes, YRD shows strong revenue growth with a strong emerging “trend” (on the surface).

Yes, YRD appears to have strong insider ownership (on the surface).

Yes, YRD appears to show strong profitability (on the surface).

Etc. Etc. Etc.

The reality is that if a bunch of smart guys at a fund like AJO consistently pick the right factors, then over time they will likely have better than average returns across their large and well diversified portfolio. But once in while they are going to have individual positions (such as YRD) that get obliterated because investing blindly in the superficial numbers will often not reveal deeper underlying problems that are found through in-depth research on a single name.

PART F: SO HERE’S WHERE QUANT INVESTING GOES WRONG

(Note that YRD deliberately cherry picks the 15-89 day delinquency rate as a proxy for bad loans. YRD discloses this metric at just 1.9%. I view this as an example of #AlternativeFacts. The data from this section below are taken directly from other disclosures by YRD. Even a cursory analysis of the disclosure shows that the situation with its subprime loans is quickly imploding from quarter to quarter. But as I see it, the low fee quant investors simply do not have the incentive structure in place to merit conducting this type of analysis.)

YRD has switched from making “prime” loans to almost exclusively making very deep
“subprime” loans.

When YRD first began making loans in 2013, it was making fully 100% of them to “A Grade” loans. This created several difficult constraints for the company.

First, the size of the pool of total borrowers who are “A Grade” is much smaller than the overall market of lower credit borrowers.

Second, “A Grade” borrowers don’t really have the need to borrow small amounts of money for discretionary purchases (after all, that’s why they are “A Grade” borrowers….). So their demand for loans is quite small.

Third, “A Grade” borrowers have plenty of other credit optionsavailable to them, such that one can only charge them a much lower rate of interest at up to 17% at best. But keep in mind that much of that 17% goes to the actual end investor (the lender on the YRD platform). YRD keeps only a portion of this as a fee. For “A credit loans”, the fee to YRD amounts to just 5.6%.

As a result of these issues, YRD was initially only able to generate a small volume of loans and was only able generate a very low level of return. In fact, because of the low 5.6% fee level, YRD disclosed that:

Grade A loans have an average transaction fee rate of 5.6%,which is lower than the average transaction fee rates for our other grades of loans, any failure to achieve a low default rate for our Grade A loans will diminish our profit margin and may even cause us to incur losses. Historically, Grade A loans have been unprofitable.

Clearly there was only one solution: Switch to subprime lending

YRD continues to disclose that it only lends to “prime” borrowers. But this is quite provably not the case. The overwhelming majority of new loans are being made to borrowers with “D Grade” credits and where APR’s run as high as 39.5%. This is quite obviously deep into subprime territory; there is nothing remotely “prime” about a short term loan with a 39.5% APR.

Starting in 2013, YRD was making 100% of its loans to “A Grade” borrowers. But by 2015, more than 80% of these borrowers were now “D Grade” credits.

The reason is obvious. “D Grade” borrowers pay up to 39.5% APR on their loans. This allows YRD to keep a much higher spread of 28.2% on these loans. In other words, YRD makes around 5x as much on “D Grade” loans as it does on “A Grade” loans. It also helps that the total demand for “D Grade” is multiples higher than the tiny demand for “A Grade”.

The result is that with subprime YRD switched into a massively larger target market whose profitability is 5x higher.

And then YRD went even further:

YRDimplemented:

· accelerated approvals (…bad)

· for subprime borrowers (…even worse)

· with even fewer credit checks (…catastrophic)

YRD disclosed:

FastTrack Loan Products

FastTrack loans are a new, fast expanding product that is currently only available through our mobile applications. These loans can be as large as RMB100,000 (US$15,437).

In 2014 and 2015, the average FastTrack loan amounts were RMB36,328 and RMB39,458 (US$6,091.3), respectively.

To apply for a FastTrack loan, a borrower completes an online application providing their PRC identity card information, e-commerce account information, mobile phone number and a credit card statement as well as the desired loan amount and duration. This product offers near instantaneous credit approval, allowing qualified borrowers to receive an initial decision in as fast as ten minutes.

Fast track is important because it means the following (in contrast to traditional P2P loans):

  • No verification of income
  • No verification of bank statements
  • Relies only on ecommerce statements and credit card statements
  • Approval in as fast as 10 minutes via smartphone

But how to entice lenders to lend to such visibly weak credits ?

Clearly lending to a Fast Track “D Grade” credit is a much different proposition that lending to an “A Grade” borrower. As a result, many investors on YRD’s platform would likely be unwilling to lend at all. Those that are willing to lend would demand a much higher rate of return.

YRD came up with a simple solution: provide a guarantee to investors that they will get their interest and principal repaid.

Even in years past, P2P lenders in China were not really supposed to be providing guarantees to lenders. As a result, YRD discloses to US shareholders that it does not provide guarantees on interest or principal. But in the past, it hadn’t really been codified into law during the nascent phase of P2P development.

Yet in the lending contract which it provides to lenders in China, we can see quite clearly that a guarantee is explicitly part of the lending contract. (See specifically clause 2.4).

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The existence of an explicit guarantee should also be 100% obviousjust by looking at the rates that YRD offers to lenders. This part requires no translation as the meaning is universal in any language.

From the following table, we can see that the rate lenders receive is identical regardless of whether the loan is being made to an “A Grade” credit or to a “D Grade” credit. The only variability shown in the rates is due to differences in maturity of the loan, where longer dated loans bear a slightly higher rate of interest (regardless of credit quality).

The following table comes from page 57 of the 20F.

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The only reason that investors are willing to accept the same rate of return regardless of credit quality is that the loan is guaranteed. Duh !This is basic finance 101 which should be obvious to any undergrad business major.

The table below shows the explosion of loans and apparent short term revenues and profits that occurred once YRD switched from prime “A Grade” loans to deep subprime “D Grade” loans with guarantees.

FY 2013 FY 2015 Increase
YRD Loan Volume $42.7 million $1.5 billion 35x
YRD Revenue $3.1 million $209 million 67x
YRD Net Income ($8.3 million) loss $43.8 million

And in fact, the explosion in deep subprime loans has continued even through Q3 2016. More than 80% of loans continue to be made to “Grade D” borrowers.

But here are the two critical problems with providing loan guarantees

Problem #1 – Loan defaults are soaring and the “risk reserve fund” is deeply under capitalized

The actual amount of the risk reserve fund is not exactly clear because YRD has made contradictory disclosures in recent earnings calls.

On the Q3 call, YRD noted that:

As of September 30, 2016, the outstanding balance of liabilities from risk reserves fund guarantee is at 7.6% of the remaining principal of performing loans covered by risk reserve fund, up from 7.2% in Q2 2016

But this doesn’t match what was said on the Q2 call:

As of June 30, 2016, the outstanding balance of liabilities from risk reserve fund guarantee is at 6.7% of remaining principal of performing loans, up from 6.5% in Q1 2016.

The fact that these numbers are changing (for the worse) after the fact is obviously problematic. But the precise number isn’t what’s important. What matters is that the number is apparently around 7%, which is far too low given the soaring rate of “charge off’s”.

Anyone who actually cares can see that “charge offs” are accelerating at a much faster rate – EVEN AMONG “PRIME” LOANS WHICH ARE DEEMED TO BE “A CREDITS” !

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If we look at loans by age, “A Grade” loans which are around 3 years old are now being charged off at a rate of 9%. And that is for the highest credit loans on the book !

It is unquestionable that we are going to see much higher loan charge off rates for deep subprime “Grade D” loans which now comprise more than 80% of all new loans.

“D Grade” loans are a much newer product so there is far less historical data. We can see the charge off rates accelerating dramatically over the period of just several months.

(click to enlarge)

Problem #2 – Providing guarantees of P2P loans in China is now explicitly illegal

The regulatory changes in China’s P2P lending market had been building for some time. Then in August 2016, it was announced that:

China’s banking regulator unveiled aggressive measures to restrain the country’s fast expanding peer-to-peer (P2P) lending sector on Wednesday, warning that almost half of the 4,000-odd online lending platforms are “problematic”…. Beijing’s hands-off approach to promote the sector as a form of financial innovation has led to a rash of high-profile P2P failures, scandals and frauds.

YRD’s share price quickly dropped by around 48% from $38 to around $20 before being bid back up briefly into the high $20s. It is now struggling to stay above $20.

CCTV (formerly China Central Television, now known as China Global Television Network) is the English language mouthpiece of China’s Communist Party. The outlet was quick to point out very explicitly that:

The regulations also ban P2P firms from providing guarantees for investment principal or returns, a common marketing practice to lure funds from unsophisticated retail investors.

“Investors must understand they need to bear the risks for their investments, no matter big or small,” said Li from the CBRC.

These are not deposits. So we are telling P2P investors: P2P is risky, investments need to be cautious.

So it could not be any more explicit. P2P firms are “banned” from providing guarantees for investment principal or returns (interest).

YRD management was quick to assure its US investors via English language news media that it was fully compliant with the new rules and that so called “risk reserve funds” were allowed.

Again. #AlternativeFacts.

As we have already seen, YRD is providing explicit guarantees. This is visible in its Chinese language contracts with lenders. It is also 100% observable via the uniformity in returns provided to investors across vastly different credit grades.

So to be clear: YRD is explicitly providing guarantees, which is illegal in China. Period.

Ok, so now the question becomes “so what”.

I do NOT expect that the regulators are going to swoop in and shut down YRD.

Instead, the problem is that YRD will soon be forced to stop providing those guarantees. Period. End of Story.

In my view, when that happens, there will be two consequences which will immediately shatter the factor models of the few “Quant” investors who currently own YRD’s ADRs.

The first consequence is that new loan volume is going to shrivel up immensely. There is a huge demand to lend money to what is perceived as “risk free” borrowers. Anyone with a bit of extra cash on hand can sign up on the platform and start generating income with virtually no (perceived) worry of repayment. These loan investors are rightfully treating these guaranteed investments as “deposits“. And this is exactly what the government has warned against.

As soon as the paradigm shifts to one of lending money to deep subprime “D Grade” borrowers who were Fast Track approved in just 10 minutes so that they could get some plastic surgery that they can’t afford anyways…well…I expect the collective desire to lend huge sums of money will shrink by at least 80%. That much should be quite obvious.

Of the potential investors who do choose to participate in such a market, they will obviously (and rightfully) require dramatically higher returns which will close in on the 39.5% that YRD can currently charge such subprime borrowers.

As a result, I expect that the 28% “spread” that YRD enjoys is also going to largely evaporate.

In fact, with lenders demanding to get compensated for the risk, we are likely to see YRD’s realizable spread fall to around the same levels that we saw for its realizable spread on “A Grade” loans. This just makes common sense. YRD was getting lenders to make “A Grade” loans to “A Grade” borrowers, such that the pricing was quite efficient. There was a clear limit to the spread that could be charged without driving borrowers and/ or lenders to more efficiently priced platforms. Once we see YRD facilitating “D Grade” loans to “D Grade” borrowers, the same market efficiency issue will come into play.

And as we saw above, YRD already disclosed that the spread it makes on “A Grade” loans is not enough to be profitable. YRD actually loses moneyon “A Grade” loans when accounting for admin and marketing costs.

Here is how to wrap your head around the new paradigm shift:

In the past and up until now, YRD has been providing an undercapitalized and illegal guarantee to lenders so that it could pay them artificially low (i.e. perceived as nearly “risk free”) interest rates when they lent out their money. But the borrowers of this money then paid full market (i.e. “risky”) rates of interest. YRD sat in the middle and collected the enormous “vig”.

Because the rate that lenders required was always fixed at very low levels, the obvious choice for YRD was to lend to whoever it could extract the highest rates from. Obviously this means lending to the worst credits possible.

On paper (and in the models of US quant investors), this all works fine in the short run. It looks as if the company is minting ever increasing amount of profits. Loan volumes are soaring and net income is soaring even more. And that is all great. But only in the short run.

In reality. this is no different that if my grandma in Boca Raton began selling hurricane insurance out of her basement to as many people as possible. Sure, she is bringing in a fortune in premiums in the short term. But she is selling insurance that she is unable to cover as soon as an “event” occurs. These economics are similar to what we see with YRD. And just as with P2P loan guarantees in China, this is why it would be illegal for my grandma in Boca to provide such a service.

PART G: YRD IS A SUBPRIME DUMPING GROUND FOR PARENT COMPANY CREDIT EASE

The reality as I see it is that YRD has largely been set up as a dumping ground for terrible subprime paper, foisting the future losses on oblivious US investors who are relying on superficial factor models.

IMPORTANT:

After reading below, it will quickly become clear why the “China Smart Money” won’t touch YRD.

It will also become clear why YRD and other P2P players are listing in the US rather than China.

It will also become clear why YRD management refuses to own shares in YRD itself.

YRD’s parent is Credit Ease, which is engaged in a variety of micro finance, inclusive finance and wealth management activities.

It turns out that most of YRD’s business is in reality a giant related party transaction with parent Credit Ease.

Credit Ease “originates” around 2/3 of the loans that go to YRD.

(click to enlarge)

Credit Ease charges a 6% fee off the top for originating, which was recently increased from 5%.

Keep in mind that Chairman Ning Tang doesn’t need to care so much about what happens to US listed YRD because he is actually the largest shareholder of Credit Ease and that’s where the real money is.

YRD discloses that:

Our agreements with CreditEase may be less favorable to us than similar agreements negotiated between unaffiliated third parties.

The slice going to Credit Ease is by far the most attractive part of the business model. Credit Ease takes its 6% cut on a huge volume of low quality loans, with zero risk, and then walks away. Regardless of what happens in the future (defaults etc.), Credit Ease makes a fortune. Clearly Credit Ease is strongly incentivized to maximize total loan volume without any consideration for credit quality. And this is exactly what YRD is doing.

US listed YRD is the middle man between these borrowers and lenders. And US listed YRD is also the one guaranteeing the exploding volume of loans being made to the lowest rung of subprime borrowers. Again, these are “D Grade” borrowers who are paying up to 40% APR. With Fast Track approvals, we can see that there are minimal verification requirements, including some which simply use the “honor system” for borrower disclosures.

P2P platforms (including) YRD typically prohibit borrowers from taking out more than one simultaneous loan. But there is no way for any of the P2P lenders to check and see if borrowers are taking out multiple loans from multiple different P2P lenders at the same time. So YRD relies on the “honor system“.

When granting loan approvals, the “use of proceeds” is also taken into consideration. For example, borrowing to make lasting improvements to one’s home would be given higher preference than, say, getting plastic surgery. But YRD has no way to verify use of proceeds, so it again simply relies on the “honor system“.

In both Q2 and Q3, there were several muted references to the massive spike in loan fraud that had hit YRD, notably in the Fast Track segment.

On the Q2 conference call, CFO Denis Cong noted that

Recently, in early July, during our regular credit underwriting process, we have discovered potential credit card statement fraud behavior from certain group of applicants for certain type of our online fast-track loans. We stopped offering this product and conducted immediate investigation. After thorough study and analysis, including systematic data checks and in person offline investigation works, we have preliminary concluded that there is likely an organized fraud incident that impacted on a group of approved borrowersmainly in early July with total contract loan volume of RMB72 million.”

In the follow up Q&A, Cong admitted that the company was writing down the full amount of this loss due to fraud.

And then by the time Q3 rolled around, we learned that YRD had actually underestimated the amount of the fraud. In Q3, YRD disclosed that the amount had now increased to over RMB81 million, roughly 15%.

In fact, I expect to see further escalation of loan fraud once we see Q4 as a result of YRD’s increasing use of Fast Track approvals to give easy credit with minimal credit checks within just 10 minutes.

PART H: Additional illegal activities at YRD

The illegal activities in this Part are not a dominant part of the equation in terms of YRD’s financial picture.

But I see them as necessary to understanding the bigger picture as we segue into the next section on potential trading irregularities in YRD ADR’s

In a report from global law firm Linklaters from August 2016, the firm made clear that under the newly released regulations from China’s CBRC, there P2P players were specifically prohibited from engaging in 13 categories of activities, including:

  • “Creating Asset Pools”
  • “Providing Guarantees” for borrowers
  • Selling “Wealth Management” products

From the sections above, it should already be clear that YRD is providing explicit guarantees. This is beyond any doubt. (regardless of what #AlternativeFacts YRD chooses to state).

According to media interviews in English:

Mr. Cong assured that CreditEase and Yirendai were “in full compliance” with the new requirements, and that the two companies were in “close discussions” with CBRC ahead of yesterday’s announcement.

(Note, in the Part below, we’re going to look at that quote again in the context of the TIMING of the sales by an affiliated Fund.)

But from what I see, YRD is also clearly “Creating Asset Pools” via its creation of a trust which invests in the loans that it facilitates. This trust was established in 2015 in an attempt to expand to institutional investors. The structure is convoluted: The trust invests in loans made through the YRD platform using funds from its sole investor, which is also the beneficiary. The name of the beneficiary is Zhe Hao Shanghai Asset Management Company, which happens to be an affiliate of Credit Ease. In April 2016, Zhe Hao then transferred beneficiary rights to a CICC “Special Purpose Vehicle” which intends to list on the Shenzhen Exchange and issue asset backed securities. In other words…. YRD is “Creating Asset Pools”.

In addition, YRD can also be directly linked to asset management firm Toumi.

Here is a screenshot of the website for iToumi.com. I have added a few translations in red. There should be no doubt that this is a Chinese asset management platform. We can also see the name Credit Ease, so that should not be in doubt either.

(click to enlarge)

But a closer look reveals that iToumi.com is actually being administered by Yirendai (“YRD”), not by Credit Ease.

Here is a snapshot of the WhoIs lookup for the iToumi.com website as it was shown a few months ago.

Obviously engaging in illegal activities is not a good thing in general. But in these two cases, the creation of trusts and the wealth management activities are not really such a big deal by themselves.

Instead, it is their links to the other activities below that are cause for much greater concern for me.

PART I: TRADING IN YRD SHARES BY AN UNDISCLOSED “AFFILIATED” FUND OF NING TANG

Following the IPO of YRD in December 2015 and then through 2016, there were issued a series of opaque and contradictory 13D’s which describe various purchases and sales of YRD shares by an unnamed “Fund” which is “affiliated” with YRD Chairman Ning Tang.

In the initial 13D, it was noted that

A fund affiliated with Mr. Ning Tang (the “Fund”) purchased 1,500,000 ADSs offered in the IPO at the initial public offering price for a total price of US$15,000,000 and on the same terms as the other ADSs being offered in the IPO. The funds used to purchase the 1,500,000 ADSs were invested by third-party investors. Mr. Ning Tang disclaims beneficial ownership of all of the ADSs purchased by the Fund except to the extent of his pecuniary interest therein.

OK. Fine. So Ning Tang “disclaims beneficial ownership” of the shares AND he notes that the funds were even provided by third party investors.

But then the 13D contradicts itself later in the filing, noting that:

After the purchase made by the Fund in the Company’s IPO, Mr. Ning Tang’s beneficial ownership in the Company increased to 46,430,000 Shares, representing approximately 39.7% of the total issued and outstanding Shares…The 46,430,000 Shares beneficially owned by Mr.Ning Tang comprise (NYSE:I) 43,430,000 Shares beneficially owned by Mr. Tang through his indirect holding of 43.4% of the total outstanding shares of CreditEase on an as-converted basis and CreditEase’s holding of 100,000,000 Shares in the Company, and (ii) 3,000,000 Shares represented by 1,500,000 ADSs owned by the Fund.

So in fact, the shares being purchased by “the unnamed Fund” are actually beneficially owned by Ning Tang.

Here is why that becomes important.

First, there were more purchases of YRD being used to support the stock when it was hitting new lows in March of 2016. Yet there was no disclosure of these purchases until 6 months later.

Those disclosures quickly become problematic.

Only in September did we see disclosure from YRD that in March (6 months earlier), Ning Tang’s unnamed “Fund” purchased an additional 300,000 ADS’s on the open market. This would have been done at around prices of $10 or even below.

These purchases were made between March 22nd and March 29th.

But by the time that filing came out in September, Tang’s fund had already begun dumping those shares, again without timely disclosure.

Between August 22nd and September 7th, Tang’s Fund sold all 300,000 of those shares acquired in March, as well as an additional 300,000 shares.

So we didn’t even know about the purchases until well AFTER the shares had already been dumped (along with hundreds of thousands more shares).

Then in a subsequent 13D from two weeks later in September revealed that the fund continued to dump a further million shares.

By this time, the Fund had now dumped around 90% of its holdings.

What is important to note here is that the Fund acquired its shares when the stock was hitting new lows and the buying served to prop up the share price in March.

But then the Fund quickly began dumping around 90% of its shares within a few weeks – within 24 hours of the new regulations being announced in China which outlaw the loan guarantees being used by YRD. Not surprisingly, the share price quickly took a significant dive.

(click to enlarge)

In the graph above, you can tell exactly when the announcement occurred in August, because that is what sent YRD plunging from its all time high near $40. You can also see that that is exactly when the Fund began liquating 90% of its shares of YRD.

SINCE THAT PEAK, SHARES OF YRD HAVE NOW ALREADY FALLEN BY 50% !

Again, Chairman Ning Tang has disclaimed his beneficial ownership of these shares, but from the 13Ds we can see that this is clearly not the case.

Perhaps of greatest importance is the fact that the Fund was began dumping 90% of its shares of YRD virtually simultaneouswith the public statements by the CEO and CFO which assured US investors that YRD had no issues with the new regulations which made its loan guarantees illegal in China.

The selling began just days BEFORE the public announcement of the new regulations. So let’s look at the quote from the interview with CFO Cong one more time.

Mr. Cong assured that CreditEase and Yirendai were “in full compliance” with the new requirements, and that the two companies were in “close discussions” with CBRC ahead of yesterday’s announcement.

PART J: Chairman Ning Tang “orders” employees to buy undisclosed US equities or be FIRED !

Imagine for a moment if there were a company which operated in the US, which employed US citizens. The company then sends out an order to all of the US employees, telling them that they must convert their own personal US dollars into Chinese RMB and then contribute their RMB into an investment vehicle controlled by the Chairman of the company. That vehicle would then take US employees’ money and buy some “unnamed” stock that only trades in China.

Sounds ludicrous right ?

Read on because according to posted leaked emails, this is exactly what YRD’s parent company appears to be doing with its Chines employees as it forces them to buy some “unnamed” US dollar stock. (The only US dollar equity that I can find tied to YRD’s chairman happens to be YRD.)

A few weeks ago, a financial news portal in China began publishing leaked internal emails between management and employees at Credit Ease. Credit Ease is YRD’s parent company and both entities are controlled by YRD Chairman Ning Tang.

What we find is an emailed employee complaint to Chairman Ning Tang as well as the emailed response from Chairman Tang to that employee.

The site posting the leaked emails is known as “Financial Gossip Girl” ( 金融八卦女)。Its web address is simply the Chinese Pinyin for that name (jinrongbaguanv.com), which now redirects you to download their App directly.

The content on Financial Gossip Girl is also available on Weibo (http://weibo.com/jinrongbaguanv).

Financial Gossip Girl is a crowd sourced portal covering the financial services industry in China. The group currently employs a group of 10 editors with professional finance backgrounds, all of whom remain anonymous.

Much of the information on the site appears to be sourced from employees in some of China’s largest financial firms. It was first established as a website in 2011 by a group of finance professionals in China. So the site has now been around for 6 years.

In 2016, Financial Gossip Girl was featured in an article in Harper’s Bazaar China which gives more detail on the group. Other scattered reviews of the site can be found on Chinese financial sites.

The group has stated that the purpose of the App is to eventually become a full social networking site for finance professional, arguably similar to LinkedIn, but with the twist that users can post detailed information on their employers.

In the US, where financial services are much more heavily regulated than in China, we clearly do not have such a site covering the financial industry. But in the pharma industry we have something quite similar in the US.

The analogy I use is that of Café Pharma (cafepharma.com) , which is a website where pharma employees in the US can log on and share very detailed information about what goes on inside. I use Café Pharma often when researching US based pharma companies and it is often exceptionally informative about what really goes on behind the scenes at Big Pharma in the US.

(For those who are interested in following Financial Gossip Girl in China, it is the App that delivers the most news in the easiest to use form. It can be downloaded from Apple’s AppStore. While I am in Asia, the updates come in throughout the day. But in the US, you can expect multiple updates to your smartphone every day during the wee hours of the morning, which gets a bit annoying.)

Here is a complete pdf file of the email posting to and from various Credit Ease employees.

(Note: I have spent enough time in China that I am more than comfortable enough reading these Chinese documents. But for the sake of objectivity I hired a professional Chinese translation firm in Los Angeles that specializes in servicing Fortune 500 firms in legal disputes that involve Chinese.)

The title of the posting was as follows:

宜信强制员工买500美元的产品,不买就被辞退!还要附带50美元手续费

The translation of this reads:

Credit Ease forces employees to buy USD500 of “product” or be fired ! Also must pay a USD 50 service fee.

The “product” here is the asset management “product” being offered by Toumi, the asset management firm listed above (which YRD isn’t even supposed to be involved with under the new Chinese regulations).

The reason that Chinese employees (who are paid in Chinese RMB) are being forced to come up with USD to invest is that this “product” of Toumi is one in which the company buys US listed equities.

References in the email below to “RA” refer to Toumi’s “Robo Advisor” which takes the employees USD contributions and then selects the investments for them. The employees do not select their own investments.

Given that Ning Tang is only connected to one US listed stock, there is only one logical choice for which US listed equity he would be forcing his employees to buy under threat of being fired. For me, the only sensible conclusion is YRD.

This view is further bolstered by the information above which shows that an unnamed “Fund” affiliated with Ning Tang was buying up shares of YRD during the course of 2016, and then dumping those shares of YRD as soon the company ran into public regulatory problems.

But with the current Toumi purchases, the benefit to Ning Tang and his Fund would be that the money at risk here is coming from thousands of low level Credit Ease employees. It is no longer his money or the money of his affiliated Fund.

The employees are employed in two different Finance groups. There is Group #1 and Group #2. Both are required to make USD investments into the USD investment “product”.

The first disclosed email shows the following:

(click to enlarge)

The translation of this reads:

(click to enlarge)

It is important to note that the deadlines for making contributionsinto the asset management “product” come before employees are paid their year end bonuses. So even if an employee doesn’t think he will be fired, he knows that his full year bonus will be in jeopardy.

Following this mass email to finance department employees, one employee wrote directly to Chairman Ning Tang. That email is shown here (name redacted, finance department #1).

(click to enlarge)

He makes a clear reference to commands from Ning Tang that those who don’t contribute to the USD investment “product” should not come to work on Monday.

(click to enlarge)

Finally, we have the response from Ning Tang.

Chairman Tang’s response is very flowery and polite. It is full of encouragement.

But at the end, he makes it very clear that contributing to the Toumi USD investment “product” is mandatory for all employees. He makes no apology or correction of the statement that employees who do not contribute will be fired.

(click to enlarge)

(click to enlarge)

The language, the source and the level of detail above cause me to believe that the exchange above is authentic. I did send an email to Credit Ease asking about this issue but I have not yet received a response.

PART K: CONCLUSION

Without even looking at YRD specifically, investors should know that investing in ANY of China’s P2P players is just downright dumb. The industry has exploded in size due to poor oversight and regulation which is already resulting in massive and widespread fraud and defaults.

This is why China’s securities regulators have sought to protect Chinese investors from P2P IPO’s and forced the P2P players to simply IPO in the US.

It is also why precisely NONE of the traditional “smart money” in China, which is present in most Chinese ADR’s, has been willing to invest in YRD AT ANY PRICE. Outside US investment in YRD consists primarily of “quant funds” who plug YRD’s attractive headline metrics into their “factor models”. I believe that they simply don’t know what they own. Likewise, YRD management also wisely refuses to own shares of YRD.

When YRD began making loans in 2013, precisely 100% of these loans were to prime “A Grade” credits. But as we saw, YRD could not generate substantial volumes of loans in this market. And in fact, YRD could not even generate a profit from these “A Grade” loans.

So instead, YRD quickly transitioned to deep subprime “D Grade” loans where borrowers pay up to 40% APRs for short term loans. Such deep subprime loans quickly comprised more than 80% of new loans being made by YRD.

To turbo charge growth even further, YRD introduced “Fast Track” loans where these deep subprime borrowers could get approved for a loan within just 10 minutes with minimal credit checks or disclosure and with the entire process being conducted by smart phone. Much of the borrower disclosure simply relies upon “the honor system”.

The result was 100% predictable: loan volume exploded exponentially as these deep subprime borrowers lined up to borrow money for such discretionary luxuries as plastic surgery and expensive vacations. In the short term, YRD appears to be reaping substantial profits from charging fees on such loans.

The problem is that no one in their right mind wants to lend to this type of borrower. As a result, to entice Chinese retail to lend, YRD offers a guarantee of interest and principle. This guarantee is shown explicitly on the loan contract shown to lenders on YRD’s web page. It is also readily apparent by observing that lenders receive the same rate of interest regardless of whether their loans are being made to “A Grade” credits or to “D Grade” credits. The rate of interest received by lenders is quite clearly being determined by the guarantee from YRD and NOT by the underlying credit of the borrower.

But in 2016, Chinese regulators made clear that such guarantees were illegal.

YRD has clearly stated that it is in compliance and that its practices are not “guarantees”. But regardless of what cute terminology YRD chooses to use we can see clearly that YRD guarantees interest and principle. This is plainly evident from:

– The lending contract on YRD’s website

– Disclosure in YRD’s 20F

– The economics being offered to lenders

YRD has cherry picked several specific very short term metrics which lead investors to believe that charge off’s and defaults are not problematic. But the reality if observably quite different.

“A Grade” loans have a longer history therefore have more data. For these supposedly “highest quality” loans, the charge off rates have already skyrocketed from 2.4% to 9% over a 3 year period. And this is for the very best of the best loans.

“D Grade” loans are more recent and therefore have less historical data to analyze. But we can already see the that “D Grade” charge off have literally exploded over just a few months, quadrupling from 1.4% to 6.2% just during 2016. And again, this is just the earliest stages for these newer loans.

The fact is that YRD likely doesn’t even need to care about the soaring defaults behind the loans that it is guaranteeing. I see YRD as just a dumping ground for deep subprime loan exposure for YRD parent Credit Ease.

Fully 2/3 of YRD’s loans actually come straight via its parent Credit Ease. Credit Ease takes a risk free 6% origination fee off the top right at the very beginning and regardless of who the borrower is. Subsequent defaults are not their concern. It is YRD and its US shareholders who bear the risk of these soaring defaults and guarantee exposure. YRD discloses that its agreements with parent Credit Ease may be “less favorable” than it would get with unaffiliated 3rd parties.

This is why precisely NONE of the management at YRD is willing to hold shares in YRD. Many of these individuals at YRD also happen to work for parent Credit Ease. Even Chairman Ning Tang only owns shares of YRD indirectly, via his ownership of Credit Ease.

We have already seen that an unnamed Fund, “affiliated” with Chairman Ning Tang was supporting the stock with large undisclosed share purchases when the share price was faltering last year. These stock purchases remained undisclosed for more than 6 months, and were only disclosed AFTER the Fund had already dumped its shares. Coincidently, the dumping of shares occurred at just the same time as the announcement of the new P2P regulations in China, which deemed that the guarantees such as YRD’s were in fact illegal. (YRD appears to have known about these new regulations in advance.)

The Fund clearly was unwilling to bear the risk of attempting to support YRD’s share price. So a different method needed.

Most recently, we can now see leaked internal emails from Credit Ease which show an edict from Chairman Ning Tang, requiring Credit Ease employees to personally come up with US dollars to invest in an asset management “product” controlled by him (Toumi).

The required deadline to make such investments was December 31st, 2016 such that any effect from it is now well behind us.

The employee US dollars were used to invest in undisclosed US equities which are determined by Toumi, without involvement by the employees. The only US equity associated with Ning Tang is YRD.

According to the emails, employees who didn’t comply would be fired.

Given the information above, it is mind boggling to understand how any sensible investor would want to get long shares of YRD at ANY price.

 

 

 

 

 

Everything in this article represents solely the opinion of the author. Nothing herein comprises a recommendation to buy or sell any security. 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 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 YRD and during the past 12 months has shared his fundamental and/or technical views with other investors. 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

$LIVE Live Ventures Exposed: Massive Paid Promotions, Heavy Accounting Manipulation, Deficient Auditor And More

Summary

  • From November to December, Live Ventures tripled on the back of aggressive paid promotions. Promoters have been paid as much as $2 million to hype Live Ventures.
  • Same promoters as imploded fraud Forcefield Energy which was delisted and went to zero. Latest LIVE bull was permanently barred by the SEC for “egregious” stock fraud.
  • Company created “earnings” via multiple one time discretionary accounting gains. Auditor was cited in 2016 for egregious and extensive audit deficiencies.
  • Company’s recent acquisition of “Vintage Stock” is effectively a continuation of now bankrupt Blockbuster, and has actually acquired its locations from Blockbuster and bankrupt Borders.
  • Live Ventures has just $770,000 in cash remaining.

Name: Live Ventures (NASDAQ:LIVE)

Inst. Ownership: 3%

Short Interest: 85,000 shares (3% of outstanding)

Cash Balance: $770,000 (28 cents per share)

52 week low: $6.00

Introduction

I first became aware of Live Ventures a few years ago when I was investigating and exposing an illegal stock promotion firm called The Dream Team Group. At the time, the company was known as Live Deal and one of the Dream Team promoters was moonlighting, also writing for another stock promotion firm. That firm was looking to recruit writers to write undisclosed paid promotions on Live Ventures.

My first article at the time exposed the Dream Team and their two primary promotions, Galena (NASDAQ:GALE) and CytRx (NASDAQ:CYTR). I then followed up with various other articles exposing many other related stock promotions. A few of them were stocks which I had shorted, but with many more of them, I highlighted their problems just for the sake of cleaning up the market, even though I had no financial interest.

As expected, nearly all of these promotions (once exposed) fell by at least 90%. Executives resigned. SEC investigations ensued. Shareholder lawsuits were filed. Some have been delisted outright and gone to zero.

As always, there had been volumes of supposed “analysis” of each of these companies’ business prospects. And, of course, in each case, the business appeared to be compelling. But as is always the case, whenever I find evidence of the individuals, promotion firms and tactics of stock promotions, these businesses ALWAYS end up failing. The purported business descriptions and developments are nothing more than manufactured fantasy. They are designed to sound great for the sole purpose of luring in retail investors. And then they fail.

In the end, there were still many other stocks which I had come across but which I never got around to writing about. In some cases, the stocks were too small and illiquid for anyone to care. In other cases, they traded for just a few pennies. And in some cases, I simply had too little information at the time to merit a full report.

But over time, some of these legacy stock promotions rear their heads again, so I do try to keep my eye on them. Live Ventures is one of those stocks.

As with the others, I will demonstrate clearly the view that Live Ventures is nothing more than a paid stock promotion with negligible business prospects. Investors have been grossly misled into bidding up the stock price by several hundred percent in just a few weeks. As investors see the true background facts, I expect the stock to quickly implode just like the others.

Preview of this report

There are so many blatant problems behind the promotion of Live Ventures that it is difficult to know where to start.

I will break this report down into the following Parts:

PART A – THE ONGOING PAID PROMOTIONS, INCLUDING THROUGH DECEMBER 2016.

Here I will show how millions of dollars have been paid to some of the most notorious stock promotion firms which happen to still be operating. Live Ventures is being promoted by the same firms I have exposed in the past and who were responsible for the promotion of stocks such as Forcefield Energy (NASDAQ:FNRG), among others. Following my exposure of Forcefield, the stock fell by 60% within days. The Chairman was promptly arrested by the FBI as he tried to flee the country. The stock was then halted and delisted, going to zero all within a few trading days.

I will show how these firms often interact with one another to obscure the nature of the ultimate paying party for the promotions. Buried deep in the disclosures, we can see that the promoters end up admitting to us that they are being paid to present deliberately skewed information for the sole purpose of making stock prices rise. The promoters have explicitly noted that stock prices typically rise sharply during their promotions campaigns, at which time they sell their own shares into the hype. Again, the information is hard to find, but in order to absolve themselves of liability, the promoters warn that most investors who invest during their campaigns will lose most or all of their money when the stock prices crash. Additional warnings (included below) should generate similar levels of concern. Wherever possible, I include the stock promotion firms involved as well as the dollar amounts they have been paid.

These promotions have been ongoing even through the month of December, even on the last day or two before the stock exploded to over $30. But now the paid promotions appear to have come to an end. The share price has been falling almost every day since earnings were released, even on light volume. Without a promotion in place, there simply aren’t buyers willing to support the stock.

Anyone who buys into the stock with this knowledge is deliberately signing up to lose money into the hands of professional stock promoters who know that the stock is about to collapse. Buying Live Ventures under such circumstances is literally downright idiotic.

PART B -LIVE BULL MICHAEL J. MARKOWSKI (BARRED BY SEC FOR “EGREGIOUS” FRAUD)

In Part B I show how Michael Markowski became an aggressive “bull” on Live Ventures just beginning in November 2016, right as the simultaneous paid promotion began to take off and the stock price began to triple. Mr. Markowski has now written on Live Ventures 9 times in less than 6 weeks. He dramatically urges investors to buy “at market” – not using limit prices and “recommends” continued purchases even as the price went higher and higher. Mr. Markowski assures investors that Live Ventures will soar to as high as $180 (a 9 bagger from current levels) during 2017. Perhaps his perfect timing on getting involved with Live Ventures was pure coincidence. Or perhaps not.

Many of the statements included in Markowski’s articles are flat out wrong. Yet investors have relied upon this inaccurate information to buy shares of Live Ventures at ever higher prices. Details on these inaccurate statements are provided below.

Mr. Markowski regularly touts his deep and lengthy expertise in the securities industry acquired over 40 years in the business. But he blatantly fails to disclose that the SEC charged him with a host of securities fraud violations which it described as being so “egregious” that barring him from the industry was “in the public interest”.

The SEC noted that

Markowski’s conduct was egregious. The complaint in the injunctive action describes the manner in which Markowski knowingly and recklessly manipulated the market prices of three Global-backed securities, including aggressive and fraudulent sales practices, unlawful solicitation of aftermarket orders during initial public offerings, and delayed execution of the sell orders of Global customers.

In other words, Markowski would use fraudulent means to induce customers to buy securities at manipulated prices and then his brokerage would prevent them from executing their sell orders (sometimes for months) even as the stocks plunged.

This is eerily similar to the content of his recent articles in which he keeps urging investors to buy “at market” and then to buy more even after the stock tripled. Investors are strongly urged to never sell.

In determining a permanent bar on Markowski, the SEC noted that:

Markowski has provided no credible assurance against future violations. Indeed, Markowski’s testimony bespeaks a complete lack of understanding of, and appreciation for, the regulatory scheme governing the securities industry.

The vast, vast majority of individuals in the securities industry will never have any sort of violation on in their history whatsoever. When the very rare person does, they will be penalized. A bar from the industry is a truly rare occurrence reserved for the worst of the worst violators in the business where the SEC feels it needs to protect investors from their further behavior.

PART C – THE INACCURATE “PROMOTION FODDER”

All promotions need some sort of talking points to get investors excited. These can often be acquisitions or other corporate events. The “fodder” is then echoed and amplified by the company in its press releases and then further hyped and promoted by stock promoters.

Live Ventures has put out multiple press releases touting tremendous new developments. In fact, we can see that the information that is touted in their press releases does not match what the company has disclosed to the SEC.

Live Ventures states that Isaac Capital Group (which is solely controlled by Live Ventures’ CEO Jon Isaac) has locked up “ALL” of its shares for 5 years, implying that the CEO cannot sell his shares.

Yet in addition to the 800,000 shares which have supposedly been locked up, Isaac has access to around 700,000 additional shares via warrants / options which have average exercise prices as low as $4.14 and which expire in less than 2 years. THE WARRANTS ARE EXCERCISEABLE IMMEDIATELY – meaning that Isaac can exercise and sell over $10 million of stock any time he wants.

Live Ventures put out a press release claiming that the company achieved EPS of $8.92 in 2016. This is WRONG and is inconsistent with Live Ventures’ SEC filings.

First off, the $8.92 which was touted in Live Venture’s press release was calculated by subtracted the 800,000 shares which Isaac agreed to lock up. This is wrong. Even in its own SEC 10K filing, Live is not able to calculate EPS this way. The number as shown in the 10K is actually $5.40. So Live Ventures has already overstated its EPS in the press release by 65%.

In fact, anyone running a text search on the 10K for the number “$8.92” will find no hits at all.

But then it gets better. Live Ventures didn’t even realize a true profit at all. Live Ventures LOST MONEY. The GAAP Net Income number provided the company was $17.8 million. But to achieve this, the company added in almost $19 million of arbitrary one time accounting adjustments, some of which appear to have no precedent in public company accounting. So in fact, Live Ventures did not post a true profit at all – instead, Live Ventures actually lost nearly $2 million.

These one time arbitrary adjustments (made at the company’s own discretion), are broken down in detail below.

Our barred “bull” Markowski has tried to spin these bizarre adjustments as a positive for Live Ventures. He has also specifically assured us that

Before conducting any additional analysis, I checked out its auditor. I discovered that it was Anton Chia, which is one of the most respected and SEC approved auditing firms.”

In fact, Anton & Chia is not even a top 50 audit firm. It was just cited (in September 2016) by the PCAOB for multiple egregious audit deficiencies, including failure to conduct proper audits in accordance with GAAP (which is exactly what I see at Live Ventures). The firm’s client list has heavy inclusion of imploded China/Asia reveres merger bulletin board stocks which trade for just pennies. Some no longer trade at all and have failed to file with the SEC. And oh, by the way, the SEC does not “approve” audit firms at all. Ever. That is not what they do. So once again, the information Markowski uses in urging investors to place “market orders” is egregiously wrong. The information on Anton & Chia is publicly available and easy to find with just a 5 minute Google search.

In November, Live Ventures announced an acquisition of “Vintage Stock” which it touted was going to bring in massive revenues to the company and involve no dilution. Given the two press releases above, investors have every right to be skeptical. Within weeks, the company was already making large downward revisions in its projections.

Until we see a detailed 8K for the acquisition, we have no idea what to expect from this acquisition. (Although I do provide more detail on Vintage below).

PART A – THE “USUAL SUSPECTS” AND WHAT THEY ARE HIDING

Live Ventures’ stock has shown a repeated pattern over time. When the stock trades at a very low price, a reverse split occurs to raise the price up and reduce the float. At the same time, some new acquisition or corporate development is announced. Simultaneous paid promotions (which have now run into the millions of dollars) help to temporarily drive the stock up. But when the business fails to produce results, the stock price falls again and the process is repeated.

The most recent promotion campaign saw the stock triple in November to December 2016.

As in the past, there was a reverse split which coincided with some sort of “news”. As in the past, there is the presence of heavily compensated stock promoters. And as in the past, the stock price quickly showed a reaction, tripling in a few weeks.

Over time, stock promoters are getting more sophisticated. In the past, their hyped-up promo material would sit out in cyberspace for extended periods of time, even after the promotions ended. This would simply provide ammunition for people like me to discredit the promotions as the stock prices began their inevitable implosions.

But now the promoters have often wised up. Their promotions usually go up on specialty sites designed just for the promotion. The promotion material is then removed once the stock price soars. After all, once the stock price rises and they dump their stock, there is no ongoing benefit to maintaining a permanent record of the promotion.

In other cases, stock promoters use huge email blasts to millions of retail investors. Because they do not appear on web sites, the information behind these promotions is usually untraceable.

Fortunately, there are some of us out there who sign up for as many promo emails and sites as possible and then store all of the emails.

And also in some rare cases we can still track down the occasional promotion that has not yet been deleted, such as the one below. (I have saved pdf copies of this because I expect the material to be deleted).

This one (“Stock Market Leader”) comes from the promotion last dated December 27th, 2016. So just a few days ago. Note that this is just before the stock soared and that the promoter was paid $15,000.

Here are screenshots of a few of the emails that came out in December and which there are no longer any records of:

So now we can see that in just a few weeks in December, around $100,000 has been spent on pumping up the stock by promoters who know that the stock is going to decrease when the short term campaign ends.

And again, so far this is just what I have been able to find. There is likely much more out there that has already disappeared.

Ultimate Stock Alerts, ProTrader Elite and Goldman Small Cap Research

Shown above are promotions from Ultimate Stock Alerts and a variety of affiliated stock promotion firms tied to Pro Trader Elite LLC. Live Ventures (and formerly Live Deal) have also been frequent promotions tied to “Goldman Small Cap Research”. GSCR is a “paid for” research firm which touts microcaps and which has no connection to Goldman Sachs. People pay Goldman to write favorable reports. That’s GSCR does.

I highlighted both Ultimate Stock Alerts and Goldman Small Cap in this exposé on the promotion behind fraudulent Forcefield Energy. Both Ultimate and Goldman were paid to promote Forcefield. Following my article, the stock was quickly delisted and went to zero. The Chairman and 8 others were imprisoned following their indictment in this $100 million fraud.

ForceField Energy: Undisclosed Promotions And Management Connections To Past Frauds

We can also see that these promoters use a maze of paying parties to obscure who is really behind the promotion. Many times, seemingly independent promotions all tie back to ProTrader Elite, which then uses a variety of different names.

My favorite is “Small Cap Firm“. Small Cap Firm gets paid by ProTrader Elite to sub-run additional promotions using the same information.

It took me days of digging to find this, but ultimately I was able to find an “orphan” page which does not appear to be linked to anything else, which describes how the promotions work and how they will affect investors. Click here to read the whole thing. But here are a few examples.

Again, these all tie back to firms (such as ProTrader Elite) which work together along with the firms who are currently receiving millions of dollars in order to promote Live Ventures.

What will happen to the shares that we hold during the Campaign?

We will sell the shares we hold while we tell investors to purchase during the Campaign.

What will happen when the Campaign ends?

Most, if not all, of the Profiled Issuers are penny stocks that are illiquid (they do not have much trading volume at all) and whose securities are subject to wide fluctuations in trading price and volume. During the Campaign the trading volume and price of the securities of each Profile Issuer will likely increase significantly. When the Campaign ends, the volume and price of the Profiled Issuer will likely decrease dramatically. As a result, investors who purchase during the Campaign and hold shares of the Profiled Issuer when the Campaign ends will probably lose most, if not all, of their investment.

Why do we publish only favorable Information?

We only publish favorable information because we are compensated to publish only favorable information.

Is the Information complete, accurate, truthful or reliable?

No. The Information is a snapshot that provides only positive information about the Profiled Issuers. The Information consists of only positive content. We do not and will not publish any negative informationabout the Profiled Issuers; accordingly, investors should consider the Information to be one-sided and NOT balanced, complete, accurate, truthful or reliable.

What will happen if an investor relies on the Information?

If an investor relies on the Information in making an investment decision it is highly probable that the investor will lose most, if not all, of his or her investment. Investors should not rely on the Information to make an investment decision.

So just how extensive has the promotion campaign been ? There is one location out there which has archived just a few of the promotion emails out there. That site does not even have the most recent mailers (which I already showed above) and it does not track to the websites such as “Stock Market Leader” (which I also showed above).

We can see that a large variety of seemingly “independent” stock promotion firms have now been paid millions of dollars to run this type of campaign on Live Ventures. As shown above, the information is only positive and consists of pure hype to drive the share price up.

In the past, one promoter, was actually paid a whopping $1 million to run a short term promotion campaign on LIVE.

Here are just a few of the many titles used in various email campaigns.

Prior to the recent 1:6 reverse split, a firm by the name of Market Bytegave us the following:

So that implies a target price of $30-42 now that we are past the reverse split. Market Byte was paid $15,000 for this.

Here is Stockapalooza.com being paid $30,000 to say to a few million email list readers:

you made a nice gain…stay tuned! LIVE could rally much higher this is a long term play Tonny

StockMister was paid $15,000 to say the following:

I want everyone to take a look at it TODAY and keep **LIVE** on your Radar for the LONG TERM!! I will be back to talk about “LIVE” at another date in time…. Hopefully it will be one this Play has already produced some INSANE Gains from it’s current low!

Again, there are well over 100 examples of such promotions on Live, with paid amounts varying from a few thousand dollars to as high as $1 million.

And again, these are just the ones we can track down. Many more have likely been removed from circulation and can no longer be found.

PART B -LIVE “BULL” MICHAEL J. MARKOWSKI (BARRED BY SEC FOR “EGREGIOUS” STOCK FRAUD)

Here are the 9 articles that Markowski has written over just the course of 6 weeks.

Before getting into the specifics on Michael Markowski, readers should take a step back and get some perspective on these recent articles. As I will show, these articles deserve a high level of scrutiny REGARDLESS of who wrote them.

Date Article Title
Nov 21, 2016 Headwinds For S&P; Tailwinds For Small And Micro-Caps
Dec 20, 2016 Live Venture (LIVE) Shares Should Be Purchased At Market
Dec 21, 2016 Case Studies Support My Prediction: “LIVE Will Be 2017’s Top Stock”
Dec 27, 2016 Continue To Purchase LIVE Shares At Market
Dec 28, 2016 Do NOT SELL LIVE Shares
Dec 28, 2016 LIVE Shares Have A New Price Limit
Dec 30, 2016 Live Ventures Diagnosed With Second Rare Cash Flow Anomaly
Dec 30, 2016 Short Activity Picking Up Due To Misreading Of Rare Balance Sheet Anomaly
Jan 1, 2017 2016 Review, 2017 Predictions And Top Pick

First, the timing is noteworthy. The author’s articles on LIVE never appeared until a massive simultaneous paid promotion was being launched on Live Ventures, including payments of hundreds of thousands of dollars to paid stock promoters. As in past promotions, this surge in promotional activity coincided with a reverse split along with multiple apparent corporate developments. Yet these developments alone had no impact on the stock, instead it was the promotions that boosted the stock. And these articles only appeared at the exact same time as the promotions.

Second, the sheer number of articles deserves attention. In the space of just 6 weeks, the author released an urgent flurry of 9 articles.

Third, the urgency and hyperbole behind the articles is unusual. The author urges readers to “buy at market” and not use limit prices, even as the stock was hitting new 52 week highs. To recommend retail investors place “market” orders on a low float small cap stock is downright irresponsible. Even relatively small orders could create large price surges, resulting in terrible execution prices for investors. Even as the price continued to rise, the author continues to urge “market” orders at higher and higher prices and then continues to raise his price target. Investors are explicitly told (in ALL CAPS) to NOT SELL shares, even as they hit a new high. (The next day the shares fell by almost 30%.)

Fourth, the blatant errors, inaccuracies and omissions deserve special attention. A few of these are included below.

Again, the point I am trying to make is that when we see this combination of problems, we should immediately start to be highly concerned about the author and his content.

But this content didn’t come from just any author. It came from Michael Markowski. That makes the problem visibly much bigger.

Markowski frequently touts his “prestigious” background in the stock market with quotes such as:

  • Named by Fortune as one of its “50 Great Investors”.
  • Acknowledged as Cash Flow From Operations (CFFO) expert by WSJ, Fortune, Forbes.com and Smartmoney.com
  • Entered capital markets upon graduation from college in 1977. Broker, IPO banker, analyst and futures trader during career

What Mr. Markowski fails to include in this “prestigious” biography is that he was expelled from the securities industry for committing extensive securities fraud and then barred by the SEC from future activities.

This was not a “minor” securities fraud case.

Instead, the SEC explicitly described the conduct of Markowski as “egregious” and noted that

Markowski has provided no credible assurance against future violations. Indeed, Markowski’s testimony bespeaks a complete lack of understanding of, and appreciation for, the regulatory scheme governing the securities industry.

According to the SEC:

Markowski’s conduct with respect to market manipulation and customer complaints regarding unexecuted sell orders demonstrates a high degree of scienter.

Scienter is a legal term that refers to intent or knowledge of wrongdoing. This means that an offending party has knowledge of the “wrongness” of an act or event prior to committing it.

According to the SEC, below is what Markowski did. Readers can note for themselves the eerie similarities to his current articles on Live Ventures.

  • Markowski “conducted aggressive and fraudulent sales campaigns to promote the securities, which included making specific price predictions about the securities”
  • Markowski then “instructed Global brokers to solicit unlawfully aftermarket orders during the distribution of the units.”
  • Markowski then “restricted the supply of these securities by discouraging brokers from accepting customer sell orders, reprimanding brokers who did accept sell orders, paying brokers commissions on buy orders but not sell orders, and fraudulently delaying the execution of customer sell orders for days, weeks, or even months.

The SEC notes that these problems were brought to the attention of Markowski by the firm’s compliance officer, but he still did nothing. Markowski came up with numerous excuses for the behavior, including blaming the problems on a fire which damaged the firm’s telephone systems. (Unfortunately, the SEC shows that the problems began well before that fire even occurred.)

The violations above occurred with at least 3 different stocks. But these violations themselves were not isolated.

The SEC then noted that:

Markowski also has a disciplinary history. He failed to provide the NASD with access to Global’s books and records in the initial stages of the NASD’s investigation of the same market manipulation at issue here. This is a serious violation of the NASD’s Rules of Fair Practice for which Markowski was censured, fined $50,000, and given a two-year suspension in all capacities and a permanent bar from acting as a principal or having any financial interest in any NASD member firm.

As I see it, Mr. Markowski has acted in a similar fashion with Live Ventures. He seeks to drive up the price in the same way, by inciting “market orders” in a small cap, low float stock. He continues to urge additional buying even as the share price soars, continually raising his target price, using specific prices as he did in the fraudulent conduct above. He then seeks to dissuade investors from selling even as the share price begins to fall apart.

The SEC also noted that following his involvement the 3 stocks above, the share prices all collapsed.

Here is a brief list of just a few of the inaccurate statements made by Mr. Markowski in his articles:

1. For Live, he stated that “Before conducting any additional analysis, I checked out its auditor. I discovered that it was Anton Chia, which is one of the most respected and SEC approved auditing firms.” As shown in the next section. Anton & Chia was cited in September 2016 for multiple egregious audit deficiencies, its clients list largely consists of imploded reverse mergers for China/Asia OTC stocks, many of which either trade for just pennies or no longer report or trade.

2. He also stated that LIVE had positive Free Cash Flow of positive $2.0 million in Q4 2016. This is provably wrong. In fact, Live Ventures had a Free Cash Flow of NEGATIVE $2.5 million. As a self described “cash flow expert”, Mr. Markowski should certainly be familiar with the standard definition of FCF: “Free cash flow (NYSE:FCF) is a measure of a company’s financial performance, calculated as operating cash flow minus capital expenditures.” It is actually very simple and well defined. Yet for some reason, Mr. Markowski decided to add $3.3 million back for prepaid expenses. This is simply an arbitrary adjustment made by Mr. Markowski to arrive at a positive number.

3. On December 20th, Markowski stated that Live Ventures has an extremely rare “Free Cash 50% yield”. As of that date, Live Ventures was already trading at $20, which would mean that Live Ventures was generating Free Cash Flow of $10 per share, or $28 million. Even using the exaggerated numbers provided above does not come anywhere near $28 million in FCF in 2016. And then it gets even better. Markowski states that: “Due to LIVE having an extremely rare Free Cash 50% Yield anomaly its share price will go to a minimum of $50.00 in 2017 regardless of how the S&P 500 performs.”

4. Stock “bulls” commonly try to blame short sellers when a stock price implodes. They try to use this to convince retail buyers to buy the stock. Markowski stated that “Based on 2.2 million shares trading on December 28th, the probability is high that short sales accounted for a significant percentage of the volume.” In fact, we can see the amount of short interest over time at NASDAQ.COM. Over the past 4 months, total short interest has ranged from 70,000-90,000, so nothing near the millions of shares that Markowski implies. From the site iBorrowDesk, we can see that total additional shares available to be shorted has seldom been more than 25,000 on any given day. And before he tries to blame the “naked shorting” bogeyman (another favorite excuse and distraction for stock “bulls”), we can see that the SEC also tracks the total amount of shares being shorted “naked”. It is called their “fail to deliver list”.For Live Ventures, the most recent number of “failed to deliver” (i.e. naked shorted) shares amounted to just 4,054 shares (yes, just four thousand shares). The reality is that short sales have accounted for virtually none of the volume. Anyone who claims 40 years in the industry should be able to find this information in just a few minutes.

5. Markowski states that “CEO Jon Isaac owns 1.1 million shares”. As shown below, Isaac controls over 1.5 million shares, nearly half of which are available for immediate sale via warrant exercise. That is a difference of nearly $10 million into the CEO’s pocket and is directly relevant when we are looking at stock promotions.

Beyond the inaccuracies we can see multiple statements which are deeply reckless in his explicit buy “recommendations”.

1. Mr. Markowski urges investors to place “at market” purchase orders

2. He also urges investors to place “Good Til Cancled Limit Orders” to buy at a price of $26.25 (even as the share price was plunging to $22). The effect of this would obviously be to support the share price.

3. He makes statements such as: “Due to LIVE having an extremely rare Free Cash 50% Yield anomaly its share price will go to a minimum of $50.00 in 2017 regardless of how the S&P 500 performs.”

4. Assuming that LIVE’s outstanding shares remain at 2.8 million the minimum price for its shares by the end of 2017 could potentially range from $45 to $180.00.

5. “LIVE’s shares are being shorted instead of being aggressively purchased. Its because should an investor or conduct a preliminary analysis and not dig much deeper the tendancy is to short instead of buying LIVE shares. Upon investors becoming aware of this anomaly the share price will go to above $100. This report will enable you to fully grasp the significance of the anomaly and why a short squeeze is inevitable.” As shown above, anyone with even a few years of experience in the market would know that this information is provably false with just a few minutes of looking.

For reference, here is the most recent short interest data from NASDAQ.COM. It shows that short interest in Live Ventures has consistently been negligible. Mr. Markowski would know that with just a single Google search of “LIVE Short Interest”.

PART C – DEBUNKING THE PROMOTION FODDER

In every promotion campaign, it is necessary to have some talking points for the promoters to sell to retail investors. This is what I refer to as the “promotion fodder”.

As will be shown in greater detail further below, each of these items has been overly hyped or misrepresented outright in promoting the stock.

In fact, even the press releases put out by Live Ventures itself contain information that does not match its SEC filings. Not surprisingly, the erroneous information is heavily to the advantage of the share price.

Fodder #1: The “lockup”

In December, Live Ventures announced that:

In December, Isaac Capital Group, our largest stockholder, agreed to lock up ALL of their shares for five years (through December 31, 2021)… Accordingly, our common stock was reduced from approximately 2.8 million to 2.0 million shares.

Isaac Capital Group is controlled by Live Venture’s CEO Jon Isaac. He is the largest shareholder.

The message here is clear. The CEO cannot sell any of his shares until 2021. Clearly this is a strong vote of confidence in the stock, and it has helped support the share price.

But that assumption is wrong. The following information can be found in the footnotes (part F-19) of the 10K.

If we look at warrants / options held by Jon Isaac and/or his Isaac Capital Group, we can see that he has control of more than 1.5 million underlying shares in total. This includes almost 590,000 shares underlying his warrants. These warrants have an average exercise price of just $4.14 and they actual EXPIRE in less than 2 years. THE WARRANTS ARE EXCERCISEABLE IMMEDIATELY.

So here is the kicker, by appearing to lock up “ALL” of his common stock, the CEO supports the share price. He therefore can get a much higher price when he sells nearly 700,000 other shares that no one seems to have noticed. Even if the original shares go to zero in 5 years, the CEO would stand to make more than $10 million if sold at current prices. Without giving the “appearance” of a lockup, this would not otherwise be possible for the CEO.

And again, the warrants can be exercised for just $4.14, they are exercisable immediately and they EXPIRE in less than 2 years. The “lockup” is nonsense.

But it gets even better. In order to effect this apparent “lockup”, the CEO “converted” his 800,000 shares of common stock into basically identical preferred shares. As a result, when Live Ventures announced their EPS for 2016, they divided their “earnings” by 2 million shares rather than 2.8 million shares. This is how the company seemingly reported an EPS of $8.92.

Live Ventures Announces Biggest Year in Company History Achieving Record Earnings of $8.92 Per Share With Continued Growth Anticipated in 2017

But that $8.92 was ONLY announced in the flashy press release. It was not included in the SEC filed 10K. (Feel free to run a text search through the 10K for yourself). In the actual SEC filings, we can see that Live Ventures was forced to report the actual EPS number of $5.40.

And as we see next, even that $5.40 was EPS was only the result of one-time GAAP earnings manipulation. Without that manipulation, the company actually would have reported a NET LOSS, NOT ANY NET INCOME AT ALL.

(We will look more closely at problems with Live Venture’s PCAOB deficient auditor below.)

Fodder #2: The supposed surge in “earnings”

The tremendous promotion surrounding Live Ventures appears to have really kicked off right around the time when Q4 earnings were announced on November 21st, 2016.

At that time, the company telegraphed that it expected “record” year-end financials would be announced in December. Many promoters as well as “bulls”, including Markowski, began amplifying these expectations and urging investors to aggressively purchase the shares.

Live Ventures certainly did not disappoint (well, at least not on the surface). On December 29th, the company announced (in a press release only) that it had reported “record” earnings of $8.92 per share.

Hype around the upcoming earnings caused the share price to briefly spike by as much as 40%, from $23 to $32. But once the 10K was released and read, the stock quickly gave up all of these gains.

As already shown above, the $8.92 number is clearly wrong. It was only achieved by using a too-small share count which was not included in the actual SEC filings. The SEC filed 10K shows EPS of $5.40.

But even that $5.40 number is not an accurate representation.

Live Ventures reported total Net Income of $17.8 million for 2016. This number is WRONG.

In the press release, the company then dividend this $17.8 million by 2 million shares outstanding to report EPS of $8.92 in the press release. As shown above, this number is also WRONG.

In calculating the $17.8 million in Net Income, Live Ventures added in multiple one time arbitrary items which it added at its own discretion. These were not the result of any ongoing business.

This included the following:

Item Amount
Bargain purchase gain on acquisition $4.6 million
Change in deferred tax expense $12.5 million
Vendor and note settlements $1.7 million
Gain on asset sales $179,000
TOTAL $18.98 million

As you can see from the names of the line items above, each of these items are non-operating items which have nothing to do with the ongoing business of Live Ventures. Together, these items count for more than 100% of the supposed “profit” reported by the company.

The bulk of these items were added at the discretion of management in a way that is simply arbitrary. They simply added them because they wanted to.

The reality is that without the benefit of these arbitrary accounting manipulations, Live Ventures didn’t show any profit at all. Instead, Live Ventures actually LOST around $1.5 million instead of EARNING over $17 million.

So the question becomes: how does Live Ventures auditor allow the company to get away with such egregious behavior ?

After earnings were released (and as the stock was quickly falling), stock promoter Markowski assured investors that arbitrary items such as “Bargain purchase gain on acquisition” were actually a strong positive for the company. He states that:

It’s pure and simple, LIVE’s earnings increased by $4.5 million due to the company being extremely conservative in valuing and negotiating an acquisition. It is what it is!

Markowski noted that:

I had never in my 40 years seen the booking of such an entry on a company’s Financial Statements….Before conducting any additional analysis, I checked out its auditor. I discovered that it was Anton Chia, which is one of the most respected and SEC approved auditing firms.

I agree with Markowski in that “bargain purchase gain on acquisition” is a very rare item. I have been deeply involved in the stock market since the late 1990’s and I have never seen it either. It is basically a made up item used to arbitrarily boost the company’s earnings.

As for the audit firm of Anton Chia, Markowski’s statements are flat out WRONG. That firm is neither the “most respected” nor “SEC approved”.

Anton Chia is not a big 4 auditor. It is not a top 10 auditor. In fact, it is so obscure that I can’t find any mention of it in the top 50 auditors. But we’ll let that slide for now.

First off, the SEC does not “approve” auditors. So that statement is flat out WRONG.

Second, in September 2016 (yes, very recently), the PCAOB disclosed egregious deficiencies in the audit practice of Anton & Chia. Their report is publicly available and easy to find.

To read all of the deficiencies noted, simply read the report. In the very beginning of its report on Anton & Chia, the PCAOB noted that:

Certain deficiencies identified were of such significance that it appeared to the inspection team that the Firm, at the time it issued its audit report, had not obtained sufficient appropriate audit evidence to support its opinion that the financial statements were presented fairly…In other words, in these audits, the auditor issued an opinion without satisfying its fundamental obligation to obtain reasonable assurance about whether the financial statements were free of material misstatement.

All told, the PCAOB cited 11 such material deficiencies, several of which appear to be strikingly similar to the accounting shenanigans that we see at Live Ventures.

Examples from the PCAOB deficiency report (published September 2016) include the following:

Does this sound familiar ?

the Firm’s failure to identify, or to address appropriately, a departure from GAAP that appeared to the inspection team to be material, which related to the improper valuation of a recorded impairment loss

Does this sound familiar ?

the failure to perform sufficient procedures to test a business combination

Does this sound familiar ?

the failure to perform sufficient procedures to test the occurrence and valuation of revenue, including the inadequate performance of substantive analytical procedures

Many audit deficiencies involve a lack of due professional care.

Anton Chia does not disclose its client list on its website. The only lists I can find are on the site “Auditor Carousel” which highlights auditor changes typically due to the implosion of the auditor or due to auditor shopping by microcap companies.

Here are the companies named as RECENT (2016) past or current clients of Anton Chia

Company Ticker Share price Market Cap
China Longyi CGYG $0.03 $2 million
Thunder Energies TNRG $0.23 $3 million
EverythingAmped N/A No longer quoted N/A
Next Group NXGH $0.02 $6 million
Malaysia Pro-Guardians MPGS $0.02 $2 million
QMIS Finance QMIS $2.50 $14 million
Borneo Industrial BOFC $0.00 Zero
Max Sound MAXD $0.01 $10 million
Vortronnix N/A None (failed to file) N/A

So it is hard to see how Markowski comes up with Anton Chia as being among the “most respected” auditors. In fact, I view having an auditor like Anton Chia as being more of an embarrassment than a mark of honor.

In any event, to me, the use of Anton Chia helps to explain how a $1.5 million dollar net loss was magically transformed into an accounting profit of almost $18 million without any underlying business activity to support it.

Fodder #3: The acquisition of Vintage (AKA the next Blockbuster and the next Borders Books)

On November 7th, Live Ventures announced the acquisition of Vintage Stock, a retailer which buys and sells things like used movies (including VHS), music CD’s and video games. The cost of the acquisition was $60 million and was done via bank financing (i.e. no stock was issued).

At the time of the acquisition, the stock barely budged. On the day before the acquisition, the stock sat at $10.98. On the day the acquisition was announced, the stock hit $11.52, up a few percent. On the next day, the stock was flat. No one cared.

The reason for the lack of enthusiasm is that trading music CDs and old video games in retail stores is not a growth business anymore. Much of this is now simply done online. Videos, music and games can simply be downloaded without visiting a store. If I want to buy a physical copy, I do so via Amazon for a fraction of the price.

Vintage continues to engage in activities such as movie and video game rentals, just like the now bankrupt Blockbuster. In fact, Vintage actually acquired many of its Dallas area stores directly from Blockbuster and brags that it now offers “over a million titles to choose from in Movies, Music and Video Games.”

Following the going-out-of-business of its local competitor Hastings, Vintage simply moved in to that location in Kerryville, TX. Vintage hopes it will do better than its bankrupt predecessor

Vintage also bought a few locations of Borders Books as that company too was going bankrupt. Vintage has stated that it follows an 80-20 rule, where the 20% consists of selling books and magazines, just like the bankrupt Borders used to do.

Vintage also engages in the odd niche business of repairing scratched music CDs, for those out there who still use music CDs.

Vintage even continues to carry game cartridges for vintage consoles such as Atari and the old Nintendo, which were popular in the 1980’s.

There was no detailed 8K released with legacy or pro forma financials, such that we don’t really know what Live Ventures purchased here. But we do know that Vintage has 40 locations spanning 5 states, with 900 employees, such that getting $60 million in bank financing should not have been difficult for the company. Vintage could have certainly borrowed that much money itself.

For example, if Vintage owns $60 million of real estate, the Live Ventures could have just paid $60 million in exchange for $60 million in real estate, with the business itself being largely worthless.

But as we have seen, stock promoters needed some fodder for their promotions. And even though Live Ventures was clearly stepping into the shoes of several bankrupt predecessors, the promoters were able to spin it for a few weeks.

The website for Vintage describes its inventory of videos, music and games as being “massive”. So a second theory is that the “value” here was simply that of over valued obsolete inventory. After all, what are rental DVD’s worth today now that everyone can simply stream from Netflix, Hulu or Amazon for just a few dollars without ever leaving their home. If Live Ventures is valuing these rental videos “at cost” of $20 or more, then a $60 million valuation could be easily justified. But obviously older titles of used rental videos now have a value which is almost nil.

Because there has been no detailed 8K filed, we simply have no idea.

But just as with the other items of fodder, the promoters have been quick to predict multi bagger share price increases based on the minuscule amount of vague and unsubstantiated information released by Live Ventures.

(Note: Here is an example of a typical 8K that virtually all companies put out upon completion of an acquisition. It contains all of the relevant historical and pro forma financial information along with the detailed terms of the transaction and financing.)

It is notable that at the time Live Ventures announced the deal in November, that annual sales were immediately expected to increase to $160 million. But just a few weeks later, this number was already quickly being reduced to $120 million. They had therefore been overstated by 33%. No explanation for the steep revision was given.

The point is this. Live Ventures completed this acquisition in November and immediately put out a press release touting several unsubstantiated forecasts. Live Ventures never put out an SEC filed 8K with any concrete details. As we have seen in the past, there have been substantial discrepancies between Live Ventures press releases and its SEC filings. We literally have no idea what Live Ventures has purchased here because nothing has been disclosed. The company is already backing away from its initial vague rosy statements.

But so far the promoters behind Live Ventures have been quick to seize on the acquisition as further proof that the stock is going to catapult upwards by several hundred percent in 2017.

Even a casual analysis of Vintage reveals that the company is in various dying businesses including DVD and VHS rentals, CD music exchange and CD/DVD scratch repair. Vintage has repeatedly been buying out the locations of other dying businesses such as Blockbuster, Borders and Hastings, all of which went bankrupt / out of business.

EMAIL AND RESPONSE FROM LIVE VENTURES

All of the commentary above has been supported with links to external sources, including the company’s own SEC filings.

I have demonstrated clearly that CEO Jon Isaac has an extra 700,000 shares which are available through warrants / options, most of which are exercisable immediately. This information can be found clearly in the 10K.

In the commentary above I also showed very clearly “what was the impact of the EPS add backs and how they were calculated”. The answer is the earnings went from $17 million to a loss of around $1.5 million. I broke down what each component was.

I also showed that the number $8.92 for EPS was included in a press release, but this is significantly different than what is in the 10K filed just 1 day later.

I did send an email to Live Ventures’ IR email address. Rather than paraphrase anything, I have included here a screenshot of the response. (Responses from Live Ventures are in blue.)

I suggest that readers read the response below and then re-read the commentary above, clicking on the links to the various filings.

I note that in the responses below, in 4 out of 5 items, the response clearly did not actually answer the question that I asked.

For question number 4 (which was answered), the company has stated that they have 71 days to file an 8K for the acquisition. This should be interesting given that the CFO was just hired yesterday.

Conclusion

Live Ventures is a stock promotion which has been aggressively pumped by some of the most notorious stock touts in the business. These promoters have been paid millions of dollars to present skewed information on Live Ventures. Buried in their disclosures is the fact that they expect the stock to rise sharply on their promotion and to then plunge when it ends. They warn that anyone who buys into the stock should expect to lose “most or all of their investment”. These are the same stock promoters who have blatantly promoted frauds such as Forcefield Energy, which was delisted and went to zero within just a few days of my report on that company.

The most recent stock “bull” to get behind Live Ventures is Michael Markowski. Markowski began writing about Live Ventures just as the paid promotion was picking up steam and he quickly put out 9 articles in just 6 weeks. He has aggressively urged readers to put in “at market” buy orders, driving up the stock. He analysis contains numerous statements which can be proven totally false with just a few minutes of checking. Markowski was barred for life by the SEC following multiple instances of stock fraud which the SEC described as “egregious”. The bar on Markowski was deemed by the SEC to be in the public interest.

The ample promotion fodder on Live Ventures is easily debunked.

The supposed “lockup” of shares held by the CEO ignores around 700,000 shares which can be sold via exercising deep in the money warrants and options. These options are exercisable immediately and expire in less than 2 years.

The tremendous surge in “earnings” from Live Ventures was simply the result of accounting manipulation, including where Live Ventures “wrote up” the assets in acquired in the past. It made these various adjustments at its sole discretion, and thus transformed a $1.5 million loss into a $17 million accounting “profit”. As shown, Live Ventures uses a penny stock auditor known for auditing imploded China/Asia OTCBB stocks. This same auditor was cited by the PCAOB in 2016 for numerous and egregious audit deficiencies, including ones which bear striking similarity to the adjustments seen at Live Ventures.

 The recent acquisition of Vintage Stock is effectively the equivalent of buying Blockbuster Video and Borders Books, both of which went bankrupt due to the transition to online viewing and downloading. Even a cursory view of Vintage’s website reveals that it still deals heavily I things like VHS cassette tapes and cartridges for 20 year old gaming consoles. The acquisition simply made for more talking point fodder for the stock promoters.

The promotion on Live Ventures has clearly come to an end. That is why the stock has been falling each day and why volume has been declining.

As the stock promoters clearly warned us:

What will happen when the Campaign ends?

Most, if not all, of the Profiled Issuers are penny stocks that are illiquid (they do not have much trading volume at all) and whose securities are subject to wide fluctuations in trading price and volume. During the Campaign the trading volume and price of the securities of each Profile Issuer will likely increase significantly. When the Campaign ends, the volume and price of the Profiled Issuer will likely decrease dramatically. As a result, investors who purchase during the Campaign and hold shares of the Profiled Issuer when the Campaign ends will probably lose most, if not all, of their investment.

Disclosure: Everything in this article represents solely the opinion of the author. Nothing herein comprises a recommendation to buy or sell any security. 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 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 LIVE and during the past 12 months has shared his fundamental and/or technical views with other investors. 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