Trouble Brewing at Farmer Bros Coffee (FARM)


Farmer Brothers coffee (FARM) was founded in 1912 by Roy E Farmer. The company is headquartered in Torrance, CA, which location also serves as a manufacturing and distribution hub.

The company became publicly traded in 1951 and for a while was profitable and paid a dividend. Yet the company has now failed to generate any annual profit since 2007. In 2011, the company cancelled its dividend, citing ongoing financial circumstances.

The company is not widely covered on the research side, while much of the institutional holdings consist of passive index funds. As a result, the share price has gradually crept up from a low of around $7 in 2012 to over $24 by late 2013. Much is this has been due to strong performance by other stocks in the coffee space such as Starbucks (SBUX) and Green Mountain Coffee (GMCR).

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The big picture at Unilife (UNIS)

Investment considerations

As bulls and bears debate their longer term expectations for revenues at Unilife, many have missed the fact that there are near term catalysts which can be expected to have a very certain impact on the share price well before these longer term forecasts have a chance to play out.

Investors should also pay close attention to the stock promotion efforts which have accompanied the recent press releases and they should be aware of some nearly identical promotions in the past. As shown below, these types of stock promotions can often create more bounce in the share price than the actual news released by the company itself.

Separately, investors who wish to assess the longer term revenue prospects should make themselves aware of the current competitive environment. Many investors appear to have missed the existence of numerous competitors with similar product offerings who already have substantial cooperation from big pharma players.

As a final consideration, many investors have engaged in substantial debate over two negative articles which were published in Forbes in September. These articles contributed to significant volatility in the share price when they discussed a whistle blower lawsuit brought against Unilife by a former employee. Many investors appear to have never read the actual lawsuit and instead have simply relied upon the interpretation as represented by Forbes. Anyone with a longer term interest in Unilife should certainly read the suit themselves and come to their own interpretation. I have included as an Appendix a link to the full lawsuit text filing along with several text excerpts.

Section 1: Long term theses vs. near term catalysts

Last week was a volatile one for shareholders in Unilife (UNIS).

On Monday, the shares had traded as low as $4.03, closing at $4.15. But after the market closed, Unilife announced “an agreement with Novartis to supply clinical products from one of its platforms of injectable drug delivery systems for use with one of Novartis’ targeted early-stage pipeline drugs”.

The mere mention of “an agreement with Novarits” had a predictable effect on the share price, and Unilife quickly traded as high as $5.25 in extended hours trading – an immediate gain of more than 25%.

These gains followed similar gains the previous week, following theannouncement of a long term supply agreement with Hikma Pharmaceuticals on November 20th. Just prior to this announcement, the stock had closed at $2.80.

After trading to as high as $5.25 in extended hours, the shares ended the week at $4.31, but had traded as low as $4.16 again on Friday. In other words, by the end of the week, Unilife had already given up almost all of its sharp gains following the Novartis release. The stock has already received price target upgrades from its three investment banks last week, but this appears to have provided very little support for the share price.

An outpouring of analysis on Wednesday added to the volatility in the share price, but appears to have not given much direction to the share price. In that one day, there were three large short articles and two large long articles published. These authors took turns repeating one another, contradicting one another and ignoring one another. All of this also happened to occur on the same exact day that CEO Alan Shortall was presenting at a conference in New York. Not surprisingly, the share price was very volatile that day, at times being down by 10% or up by 5%. It was equally unsurprising that the share price finally ended the volatile day almost entirely unchanged (up by just 2 cents).

The bull thesis is based on the opinion that this recent series of supply agreements will ultimately produce perhaps hundreds of millions in revenue from big pharma partners. However, even the bulls acknowledge that meaningful revenues are not expected to materialize until after several ramp up periods of as long as four years.

The bear thesis was fully detailed by Kerrisdale Capital which notes that recent announcements from Unilife are nearly identical to numerous announcements stretching back 10 years, each of which suggested that the onset of massive revenues was imminent. Such announcements had consistently caused the share price to soar dramatically, just as they have again done in the past two weeks. As they have been recently, analysts were then quick to upgrade the stock. Yet revenues for Unilife have continued to dwindle while Unilife has steadily issued nearly 40 million new shares in just the past few years.

For those looking to trade the stock, the inherent problem with both of these bull and bear theses is that both are predicated on how potential contracts and revenues will play out over a period of several years. Given the tremendous volatility in the stock recently, long term views may not be of ideal use.

Both sides are free to speculate on the longer term future of Unilife. However in the near term, one thing is quite certain: By the end of December, Unilife will likely be out of cash and the company is almost certain to issue a substantial amount of equity before the Christmas holiday. This is the near term catalyst.

Author Dr. Hugh Akston illustrated this catalyst quite clearly in a recent article. As of September 30th (i.e. two months ago, its last reported quarter), Unilife was down to just $7 million in cash. The company steadily burns around $3 million every month. The company did receive $5 million as an upfront payment from Sanofi in October, but Unilife has already disclosed that it plans on paying down a loan to Varilease for roughly that amount. As of right now, Unilife is therefore down to around $1 million in available cash vs. its consistent cash burn of around $3 million per month.

The incentive to conduct a very large equity offering is clearly substantial. Last week (following the sharp spike), Unilife had quickly risen by nearly 90% and was trading at its highest levels since 2011. But this is simply on a “nominal” share price level. In reality, the large number of shares which have been issued every year means that last week Unilife was closing in on its highest evervaluation (market cap) since coming public in the US. Some investors may not realize this given that the share price has fallen from above $10.00 to around $4.00 at present. Yet it remains the case that the market cap for Unilife had just hit within around 10% of its highest ever valuation since trading in the US.

The recent upgrades by Unilife’s investment banks were all based upon enthusiasm for the Novartis announcement. Yet these banks are not privy to any additional information beyond the press release, which we can all read equally well. The banks simply relied upon this simple press release to provide generous upgrades to their share price targets. Such jockeying for position ahead of a near term equity financing suggests that these banks are looking for an equity offering that will be bigger rather than smaller and which will provide millions of dollars in investment banking fees to whoever is selected by Unilife. Currying favor with the company by upgrading the stock should therefore have been fully expected. These upgrades have failed to support the stock, so it appears that the market has already come to this realization on its own.

Section 2: Evaluating the stock promotion efforts

When looking at the “big picture” at Unilife, investors need to understand that there is an active effort at stock promotion which has been going on for quite some time. The details from this particular effort are virtually identical to other stock promotions, some of which I have highlighted in past articles.

Here is how it typically works. (And readers should keep in mind that I am not specifically referring to Unilife in this description. I am referring to a cookie cutter process that can be seen very frequently across numerous micro cap reverse merger stock promotions)

In each case, the promotion involves a small, money losing reverse merger which supposedly has the potential for massive near term transformation along with billions in revenue potential. At some point, the company issues one or more press releases which happen to mention global mega giants within its industry. Specific terms which would allow for proper revenue forecasting are typically not disclosed for competitive reasons or due to “confidentiality”. The share price often moves to some extent based on these press releases. But much sharper gains appear when certain third party authors interpret these press releases for us and then issue massive multi bagger share price forecasts. Share prices can then often show additional gains of more than 50% in a very short period. But the gains are typically very short lived. Over time most of these promotion efforts end up giving up all of their gains, and in many cases they end of falling even further, for reasons that will be shown below.

On Friday, author Tech Guru weighed in once again to help us “parse” the debate on Unilife. He notes that he expects $50 million in revenue in 2014. By way of comparison, over the past 5 years, Unilife has generated a cumulative total of only around $25 million in revenues. But most of this came in 2010. More recently, revenues have dwindled to around $0.6 million per quarter. During this time span of several years, Unilife has repeatedly issued similar bullish forecasts which made statements such as:

we have been swamped with demand from a lot of other pharma companies who also have unmet needs.”

“We expect to be supplying this to many pharma companies in the near future,”Allan said.”

Past press releases dating back as far as 4 years include the following. (Note these are all PRIOR TO 2013, and as such should have already had an impact on revenues).

2010 – Unilife and sanofi-aventis Agree to Exclusivity List for Unifill(TM) Ready-to-Fill Syringe

2010 – Unilife and Stason Pharmaceuticals Sign Asian Distribution Agreement for the Unitract(TM) 1mL Safety Syringe

2011 – Unilife Signs Clinical Development and Supply Agreement with Global Pharmaceutical Company

2011 – Unilife Wins Supply Contract with Nation’s Largest Healthcare Alliance

2011 – Unilife Starts Unifill Syringe Sales to Another Pharmaceutical Customer

2011 – Unilife Commences Initial Supply of the Unifill® Syringe to Sanofi

2011 – Unilife on Schedule to Fill Initial Orders for Unifill Syringe

2012 – Unilife’s Bolus Injector Platform Targeted by Global Pharmaceutical Company for Use in Multi-Drug Program

2012 – Unilife Signs Long-Term Supply Contract for the Unifill Prefilled Syringe

In many cases, these press releases were just as exciting as the recent ones in 2013. They also consistently provided (very brief) boosts to the share price of Unilife as expected.

But the results have varied dramatically vs. expectations.

The points from these graphs demonstrate the following: the share price has been steadily declining for the past several years, even as Unilife has consistently issued millions of new shares. Likewise, revenues have dwindled by more than 70% while losses have grown substantially. All of this has occurred despite the consistent release of “news” from Unilife which has been largely similar to that which was released in the past few weeks.

It is therefore unclear how Tech Guru could be so optimistic regarding a tremedous surge in revenue next year.

A few months ago, I highlighted a different campaign by Tech Guru with Neonode Inc. (NEON), which appears to be nearly identical to the promotion of Unilife in virtually all respects. The similarities and parallels here should be patently obvious to anyone who has followed Unilife.

Tech Guru began writing on Neonode earlier in 2013. Between March and September, he wrote bullish articles on the company on average every 2-3 weeks. Neonode is engaged in licensing touch sensor technology, mostly to electronics OEMs.

Just like Unilife, money-losing microcap Neonode had put out several very promising press releases this year which could be linked to global giants within its industry. Over a period of months these included such heavy weights as Samsung and LG, along with automotive contracts with Volvo. Clearly this was going to be huge and transformational.

Just like Unilife, Neonode had been putting out nearly identical press releasesfor years, but consistently failed to generate meaningful revenues – despite the global giant partners. Just like Unilife, Neonode has never earned a profit in its numerous years in business. And just like Unilife, the press releases from Neonode were always kept vague and omitted the most relevant details, typically due to competitive or confidentiality reasons.

Given that multiple years of nearly identical press releases from Neonode failed to produce large scale revenues or any profits at all, it is unclear why Tech Guru would project that more identical press releases in 2013 would somehow lead to near term windfall profits and a skyrocketing share price. But by trumpeting names like LG and Samsung and predicting returns of more than 400%, his articles did cause the share price to briefly rise by around 60% to as high as $8.84 up from around $5.00 in March.

Just like with Unilife, the investment bankers were quick to upgrade Neonode based on nothing more than the very vague press releases. Investment bank Craig Hallum initiated coverage on Neonode when the stock price was just $3-4, and put a target of $7.50 on the stock, implying that they expected Neonode to double. The timing of this coverage was downright bizarre given that Neonode had just lost its largest customer, Amazon (AMZN), which had been responsible for 40% of its revenues at the time. But the upgrade worked and Neonode rose. By August, Neonode had still failed to replace its lost revenues and reported a notably large earnings miss which sent the stock plunging by more than 20%. What did Craig Hallum do ? They upgraded the stock again – now with a $10.00 target. This upgrade, along with more bullish articles by Tech Guru (predicting a $27 share price) sent the stock to just under $9.00. This sequence of events is all detailed clearly in my September article.

By now, this sequence of events should all feel very familiar to those who follow Unilife. So far they have been largely identical.

What happened next with Neonode was quite predictable. Neonode and its management sold $19 million in equity. Craig Hallum ran the deal (as expected) and made millions in fees. Meaningful revenues from the mega announcements may still be years away (if ever) and the stock price quickly fell by around 30% back to around $5.00 – right where it began. Prior to the offering, Tech Guru had been writing bullish articles on Neonode every 2-3 weeks for a 5 month period. This was a dedicated and persistent effort. But following the offering, the articles suddenly ceased for several months.

Many investors may wonder if such promotions can actually have a meaningful impact on the share price. The answer is a categorical “yes, they can”, especially if executed by a professional. This point can be made clear with a separate example.

Lately the Novartis news has taken center stage to the point where many investors have stopped focusing on the recent Hikma news from November 20th. The Hikma announcement caused Unilife to soar by more than 30% to $4.03. But after the initial surge, investors began a meaningful sell-off as they fully evaluated the news. It was only a double promotion from a paid subscription service called “The Focused Stock Trader” that sent Unilife soaring.

The graph below illustrates the sequence of events.

– Nov19 / 20 – Unilife announces Novartis news – stock rises to $4.03

– Nov21 – UNIS stock immediately trades down as low as $3.63 (down 9.9%) closes at $3.73

– Nov22 – 25 – UNIS struggles to hold above $4.00

– Nov26 – TFST promo article to paid subscribers only – UNIS immediately jumps from $3.85 to as high as $4.38 (13% jump and a new 52 week high).

– Nov27th – TFST article released on SA at 2:35 pm – stock jumps again from below $4.20 to as high as $4.50 (breaking yet another 52 week high)

– Nov28th – Thanksgiving – market closed

– Nov29th – Friday – stock closes at $4.40

– Dec 2nd – Stock closes at $4.15 (down 6%) hitting a low of $4.03 again (right where it began)

– Dec 2nd (after market close) – Novartis news released

The conclusion from this is that the stock had been quickly falling below $4.00 until it was pumped up by TFST and his distribution to his subscriber and then the follow through on Seeking Alpha. The stock was quickly losing momentum again, and the only thing the resurrected it was a new press release regarding Novartis.

TFST is a paid stock promotion letter. According to its results page, TFST is among the best investors in the entire stock market throughout the history of time eternal. Better than Buffet, Ichan or Soros by a long stretch. It notes that:

As our results show, The Focused Stock Trader recommendations were correct 52 out of 55 trades for an average return of 29.69% per trade with 2 trades generating returns in excess of 200%. The average holding period for our recommended trades, not including open trades, is 24 days. THE FOCUS STOCK TRADER HAS BEEN CORRECT 95% OF THE TIME GENERATING 30% EVERY 24 DAYS.

Apparently by following TFST, one can quickly become immensely wealthy. Fortunately, TFST makes its expertise available to the public, for anyone willing to pay $400 per quarter ($133 per month) or $1,200 per year ($100 per month). Based on this, it is very easy for TFST to pull in a 6 figure income from subscription revenue irrespective of the performance of any trades it recommends.

closer look at TFST reveals that many of these stock picks end up being for very speculative reverse mergers which demonstrate great volatility. The research underlying them is often questionable, yet TFST has apparently generated significant returns on the upside, quickly selling before these stocks fall back to Earth.

For example, back in August, TFST highlighted Organovo Holdings (ONVO). Histrack record notes that he had sold the stock for prices as high as $11.20. But when the stock was trading at over $12.00, I highlighted the fact that much of its gains were due to misinformation and inaccurate comparisons to 3D printing stocks such as 3D Systems (DDD) and Stratysys (SSYS). The article from TFST contains the exact type of misinformation that I had referred to. He noted that

Needless to say, Organovo can do for 3-D printing what Microsoft (MSFT) did for PCs and Ford (F) did for the automobile; make a long-sought after dream a reality.

Shortly after TFST was selling at $11.20, the stock quickly ended up falling below $8.00. The stock has recently jumped due to the CEO’s presentation at But even on that conference, the CEO went out of his way to make clear that Organovo is NOT a 3D printing stock.

TFST clearly benefited from the rise in the Organovo even though its research was largely unfounded. So, what’s the harm ?

The harm is that when stock promoters put out unfounded research on tiny, speculative reverse mergers, investors end up buying into these stocks without understanding that there are very substantial risks. TFST’s next pick was Fab Universal (FU), which he ended up making a whopping 99% on, selling it at $10.75. Congratulations to TFST, however that stock has since been halted after a fraud expose by GeoInvesting. Prior to the halt, this stock had last traded at $3.07. Trading has not yet resumed. Anyone who has been stuck holding a Chinese microcap which has been halted due to fraud allegations would likely not hold much optimism for the future of Fab. TFST was smart enough to get out at $10.75, but its subscribers may not have been so lucky. On its website TFST notes that:

In our reporting, we will suggest the purchase point; however, it is up to you to decide when to close out the position.

Likewise, on Unilife, we will have no idea how quickly TFST will end up running for the exits. In fact, it may well be the case that TFST will have the benefit of selling to individuals who are still buying based on research provided by TFST. That advantage, along with over $100,000 per year in subscriber income, makes for a great business model for TFST.

A longer look at the TFST track record shows a predisposition towards speculative and volatile reverse merger stocks which often end up in the cross hairs of short sellers. Revolution Lighting (RVLT) which TFST was selling as high as $5.00 was later exposed by a short selling and fraud focused site the StreetSweeper. The stock subsequently fell by as much as 50% from where TFST was selling, and it now sits at around $2.80. But it appears to have been another great trade for TFST who got out early. Likewise, it is very difficult to understand how anyone could have ever recommended beleaguered OCZ Technology (OCZ) which has been on terminal status for over a year.

TFST had noted that :

Short sellers are still holding on, but perhaps not for long. OCZ’s short position is at an unsustainable 79.3%.

Within a month, the shares had already plunged by around 80%. Since that time the shares have fallen by more than 95% and now trade for around 10 cents. It looks like there was a reason why the short interest was so monumental.

Yet OCZ has continued to be a promo pump target even now. Ashraf Eassa recently warned that there is still a pump campaign trying to spread rumor of a buyout on this now dead stock.

In separate disclosure on November 29th, TFST noted that his holding periodwas as short as just 14 days. The point is that small reverse mergers can often pop due to the sensation which surrounds vague press releases. This is especially true when the press releases include the names of major, global industry players. As players such as TFST have demonstrated, the best way to profit from such hype is to buy the rumor and (very quickly) sell the news.

The promoters behind Unilife have demonstrated a consistent tendency to back speculative, money losing reverse merger stocks. As with TFST, other backers have found themselves on the opposite side from short sellers.

Tech Guru had previously penned an article to rebut the short thesis on Coronado Biosciences (CNDO). Coronado had the implausible idea of making medical treatments out worm eggs which grow on pig feces. Tech Guru sought to debunk the short thesis which had been highlighted again by such skeptics as the StreetSweeper.

In its “public oath” the StreetSweeper states that:

We aim to partner with the public in exposing corporate fraud and bringing its engineers to justice. To that end, we pledge to investigate credible allegations of misconduct and – if the evidence supports those accusations – report the truth about our findings. At the same time, we agree to disclose any conflicts that could potentially color our judgment. By embracing these core principles, we hope to protect ordinary Americans and deliver them news that they can trust.

Readers can take that “public oath” with whatever grain of salt that they like. The point from it is that sites such as the StreetSweeper do not focus on stocks which are merely overvalued by 10-20% or which might have a bad earnigs quarter. They are focused on catalysts which are far more dramatic and which imply far larger share price moves.

As with Unilife, the shorts made their case by saying citing a horrible track record by management, including huge share sales despite no revenues. In backing this company, Tech Guru was defending the indefensible. As should have been expected, the use of worm eggs from pig feces failed in clinical trials and the share price plunged from over $8.00 to as low as $1.25. Yet the elevated share price before the failure allowed management to raise over $200 million from stock sales over the past few years. The shorts were particularly focused on the fact that a small group of insiders had been repeatedly involved in similar speculative ventures which soared on the hype but which imploded following large share sales. Since the implosion of Coronado, Tech Guru has ceased providing further updates on the company.

The point from these examples is that generating excitement around tiny reverse mergers which generate little to no revenue is far easier than generating excitement around larger companies which are profitable and stable. This is precisely why promoters choose such companies. Yet by ignoring or denying the warning signs highlighted by the skeptics, these promoters can often encourage other investors to invest in stocks which have very significant (and unknown) downside potential.

Other Unilife bulls appear to be engaged in a different strategy when writing about Unilife.

In the past year, Fusion Research has gone from zero articles on Seeking Alpha to almost 400. A new article appears from them on almost every trading day, with the result that Fusion is now #1 on long ideas, #1 on services stocks and #1 on industrial goods. These rankings are based purely on number of hits.

Fusion describes itself saying:

Fusion Research is managed by a team that has been actively involved in the financial research industry for over 5 years. Our business is rooted in principles of trust, integrity and fundamentals-driven markets.

But it also notes that

We create strategic partnerships with companies and firms to gain unprecedented domestic and international following of our coverage.

In fact, a closer look at Fusion’s own website reveals that Fusion is actually an IT outsourcing firm which focuses on simple web development and HTML. There is a link where once can “learn more” about its investment research activities. But that link is broken and leads to nowhere.

In its almost 400 articles, Fusion has consistently written about mega cap stocks which have a huge built in following of thousands of readers. But it has also made it a point to write about smaller stocks which have recently shown dramatic price moves and which will also automatically generate a large number of hits.

The key point is as follows: During a two week period, shares of Unilife soared by as much as 88% on the back of two press releases which are encouraging but still far too vague for planning or forecasting purposes. Prior to this, the shares closed at $2.80 and the shares have already begun a substantial retreat.

The attention of promotional authors can often have an even larger impact than the news from the company itself. While this can often create great short term trading opportunities for those who are nimble, holding these stocks after they peak can end up producing substantial losses on the way down. Investors should be aware that those who promote such stocks often have zero intention of holding the shares and often intend to play it as a quick “buy on the rumor trade”. Other authors are simply attracted to the most volatile stocks which tend to generate the largest number of page views and typically do not even buy the stocks they are writing about.

Section 3: Competitive considerations for Unilife

Many of the recent articles have been overwhelmingly focused on highlighting the dramatic upside associated with Unilife, while downplaying the substantial risks of buying on this spike. They have also ignored the competition.

There is a reason why promotional authors tend to ignore the risks and competition: it works.

We can very easily see what happens when an author pays even moderate attention to risk elements after a stock has already spiked. Once the stock has spiked, any attention to risk can send it sharply lower.

On December 2nd, Dr. Thomas Carr wrote a very bullish article on Unilife entitled “Unilife: Set To Double In 2014?“. In his opening pitch, he notes that he is long the stock and that:

As it turns out, demand for Unilife’s unique medical dispensing technology is so strong and growing so fast that shares of the company may well be one of 2014’s best investments in the healthcare sector.

What was the result of this strong enthusiasm from one who identifies himself as a “doctor” ? The stock actually fell 7% that day. There are two reasons for this.

Despite his own personal bullishness and disclosing a long position in the stock, Dr. Carr was forthright enough to at least mention the substantial downside that comes along with Unilife. He noted that:

New and current investors should keep in mind the risks outlined above. The company may well be covering up past fraudulent activity. The Biodel deal may well fall through. Management may continue its unfortunate streak of over-selling its EPS potential.

But of much greater importance was the fact that Dr. Carr was among the first to pay more than passive lip service to the existence of substantial competition within this market.

Even Unilife itself discloses that there is meaningful competition in this space. But the mostly retail investor base in Unilife often seems to feel that Unilife is inventing a new product and will quickly command a monopoly in the space.

In its most recent 10K filing, Unilife discloses its view on the competition which already consists of some of the largest and best financed giants in the healthcare industry, saying:

We are aware of five companies which specialize in the production and supply of glass ready-to-fill syringes. These companies are BD, Gerresheimer, MGlas AG, Schott and Nuova Ompi. We estimate the market concentration rate for these five companies to be approximately 95%. We believe BD’s market share to be in excess of 50%, as it has supply relationships with most pharmaceutical companies and contract manufacturing organizations.

The point that investors need to realize is that this is not a soon-to-be-created new market which will be dominated by Unilife. It is already an established and highly competitive market.

In September, the big news for Unilife was the Sanofi contract which may eventually lead to meaningful sales of Lovenox in prefilled syringes. But in its September conference call, Unilife noted that

the IMS data for Lovenox for 2012 shows the sale of over 450 million prefilled syringes with Lovenox in it.

The point is that there are already hundreds of millions of units of being provided by competitors on the market two years before Unilife even plans on entering the picture in 2014. Many investors have been entirely unaware of this competitive reality and have assumed that Unilife is about to create a multi billion dollar monopoly.

Dr. Carr briefly listed a number of Unilife’s competitors within the space who have existing or pending product offerings which will largely compete within the same space.

In addition to Beckton Dickinson (BD), Gerresheimer, MGlas AG, Schott and Nuova Ompi (which were mentioned by Unilife), Dr. Carr also mentions such giants as Amgen (AMGN), Pfizer (PFE) and West Pharmaceuticals (WST). Medical giant Baxter International (BAX) is also active in prefilled syrniges. Baxter is valued at $37 billion based on annual sales of over $14 billion.

The point is that breaking in to this space will be difficult, even despite several encouraging potential supply contracts. The competition in this space is well established and extremely well financed and will have the ability to compete aggressively on volume, quality and price.


The market has now had the opportunity to digest in full the recent news from Unilife along with the ample analysis from third party authors. CEO Alan Shortall has had the opportunity to speak to investors in New York and the sell side analysts have already had their chance to upgrade the stock.

With all of these events now being mostly digested, the stock appears to be once again giving up its recent gains rather than continuing to surge higher.

The market may well be already pricing in an equity offering due to the realization that Unilife will likely be out of cash before Christmas.

Much of the sharp rises in the stock can be tied to recent promotional articles by authors who tend to focus on short term trades in speculative reverse merger stocks. In the past, some of these efforts have sensationalized press releases from other micro cap reverse mergers and have predicted a surge in near term revenues and multi bagger share price returns. This is an easy task when the press release includes the names of global giant heavy weights.

But when similar such press releases have been consistently issued for years without meaningful resulting revenues, investors should likely ask themselves how the latest series of press releases will create a result that is in any way different.

There is already existing competition in the specialty syringe space, with hundreds of millions of units being delivered even just for individual drugs such as Lovenox. Those who have been under the impression that Unilife has created a novel product and will soon be commanding a monopoly would do well to expand their research into the substantial competition in the specialty syringe space.

Appendix I – details of Unilife lawsuit

For those who wish to read the details of the Unilife lawsuit in their entirety, updating filings from August can be found at the following link at my website Readers can also sign up for email alerts. There is no charge for this and email addresses are not shared with anyone. Ever.

Readers should also be aware that Unilife has already responded to the article on Forbes. A link to that response can be found here. However, readers should also note that there are a number of items in the actual whistle blower lawsuit which do not yet appear to have been responded to by management.

The lawsuit was brought by Talbot Smith, formerly an executive at Unilife who was hired in 2011. The suit notes that Smith was a Stanford graduate with a BS in Industrial Engineering and an MS in Operations Research. His starting salary was $230,000 plus various incentives including bonuses and stock options.

The gist of this lawsuit can be seen on the first page of the filing. The cited “causes of action” are a) violations of Sarbanes Oxley and b) violations of the Dodd-Frank Act.

Sarbanes Oxley (or “SOX”) was passed in 2002 in direct response to various accounting scandals including Enron, Tyco and Worldcom. SOX requires that top management certify the accuracy of SEC filings and dramatically increased the penalties for fraudulent activity.

Dodd Frank was passed into Federal Law in 2010 in response to the financial crisis which began in 2008 and also was designed to incorporate enhanced protections for investors.

As noted, the lawsuit was originally filed and received by the US Department of Labor/OSHA. The lawsuit notes that the Secretary of Labor did not make a final determination within the 180 day deadline, but that “sufficient prima facie evidence was found to begin an investigation” (page 2). As a result, the case was moved to Federal Court.

This filing is very long because it also incorporates original copies of the press releases and the 10K filing which are said to contain the inaccurate statements.

Some of the claims by Smith state that products being supplied by Unilife were not “validated” (as had been claimed by Unilife) because the FDA required activities had not been completed at the time that these statements were made to investors. Unilife subsequently brought in FDA auditors who stated that by the time of the audit, the validation could be considered complete.

These FDA claims will therefore be very difficult for either side to verify. The argument Talbot would make is that compliance would have been achieved well after he reported his observations to the FDA, but prior to the audit. The argument from Unilife is simply that this is not true.

Other claims should be less ambiguous. For example, on page 7, we can see Smith’s claim that the previous 10K filing made inaccurate statements to investors regarding shipments of “commercial” product by Unilife. Talbot backs this statement by noting that “no revenue had been collected from commercial sales of the Unifill product”. Ultimately, an audit by the SEC will be able to trace documentation of this claim and make a determination. This should be black and white.

Likewise, Talbot claims Unilife made false statements about its production lines. Talbot claims that at the time of the statements, two of the production lines were actually still in Denver, Colorado, and certainly not installed. Again, this should be a very black and white matter to resolve in an investigation.

In general, I am far less focused on the FDA issues because I believe that they will be far more difficult for either side to resolve. But on Page 11, the lawsuit describes additional product quality failures which had supposedly been reported by Smith via email. The lawsuit then notes that

The following day, Mojdeh told Smith to come into his office. Mojdeh instructed Smith that he should not put any concerns into emails because they could be used against the company in future legal action

Once again, an investigation will certainly dig up any emails prior to this conversation. Either the emails referred to by Smith exist or they do not, so there should be a conclusive result to an investigation by the SEC.

Other claims may be easy to document, even though actual “intent” may be hard to prove. On page 11, the lawsuit notes that:

Unilife also took actions to mislead investors about its customer demand and manufacturing capacity. To this end, Mojdeh directed Smith to have his team purchase 1,000,000 units of Unifill components per month in spite of the fact that there was no customer demand or manufacturing capacity to justify this level of purchasing. Mojdeh told Smith that the objective of the purchases was to make suppliers believe that Unilife was manufacturing at this volume, with the hope that the information would leak to the financial markets.

The point here is that proving that Unilife made unnecessary purchases at huge volume should be relatively straight forward. And this could easily be explained by the ballooning losses and dwindling revenues seen over the past 3 years. Yet actually proving the intent of Mr. Mojdeh will likely be a more difficult endeavor in an investigation or a courtroom.

On page 12, the lawsuit states that:

Another action that Unilife took to mislead investors was to run fake production when investors or customers were visiting the facility. On more than one occasion, scrap was run through the machines to make it appear that Unilife was making product when it was not. Product was placed on skids by the warehouse doors to give the false appearance that product was being packaged and send to customers when it was not.

Presumably the only way to get much resolution will be when the SEC subpoenas the warehouse workers who either did or did not perform these activities. The truth should be easy to get at because warehouse workers typically do not have a large financial inventive to bend the truth when faced with the potential for perjury charges. In addition, there are likely a large number of warehouse workers. Keeping a secret gets harder as the number of individuals increases.

On Page 13, the lawsuit notes that

Shortall made comments that were posted on the Yahoo! Finance message board on July 10th, 2012, indicating that Unitract was profitable with a 20% gross margin, when Unilife was in fact losing $1.00 per unit.

Again, this will be an easy one to either prove or disprove.

Conclusions regarding Unilife lawsuit

The details spelled out in the lawsuit vary between crystal clear and verifiable to murky and difficult-to-prove. Some investors may be inclined to wonder why we have not already seen some resolution to these matters given that they relate to issues dating back to 2011. Other investors may be inclined to feel that if we haven’t seen consequences yet, then there may simply be nothing to worry about.

In general, SEC investigations take considerable time and there are no “hints” along the way which would given guidance as to the eventual conclusion. For example, in October 2013 the SEC was just providing final resolution to the fraud case at YuHe International, which has been ongoing since 2011. China frauds were a big focus in 2011, and in October 2013 the SEC finally got around to issuing final judgment against China Media Express (“CCME”), also following fraud that was uncovered in 2011. The point is that these things can often take a few years before visible results are uncovered. No one should expect that there would have already been an immediate result just because these findings were made public over a year ago.

Disclosure: I am short UNISONVO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Organovo set to fall by 50%

Investment overview

Shares of Organovo Holdings (ONVO) have recently skyrocketed due to widespread media coverage and an equally widespread misunderstanding of the company’s near term revenue potential. The stock has risen from $2.00 to over $13.00 in the past 12 months and is now valued at over $1 billion. To date Organovo has generated no real commercial revenues, but has brought in small amounts of money from grants and collaborations. The company hopes to launch its first commercial product, a 3D liver assay, in December of 2014, 13 months from now. A launch of any possible next products has not been announced or discussed, but would likely take several more years for any visibility. So for now, this one product is all that there is to hope for for the next few years.

Continue reading…

TearLab to plunge on steep earnings miss

Investment thesis

TearLab Corp (TEAR) has so far managed to drive moderate increases in revenue over the past year, but only by spending a disproportionate amount on marketing. The result has been ballooning losses in every quarter. The company has never earned a profit. Following dozens of recent calls to the offices of eye doctors, it has become apparent that the adoption of the TearLab product tends to be fleeting and driven primarily by the marketing spend. As a result, the temporary boost in revenues resulting from this marketing tends to be short lived and must be constantly replaced with new doctors who will give the product a trial. Investors should be concerned that TearLab now gives away its desktop reader for free in order to encourage doctors to make a trial of the product.

TearLab recently laid out a large seven figure pay package (roughly in line with a full quarter’s revenue) to hire Seph Jensen from Alcon Labs. His start date was scheduled to begin just prior to the upcoming earnings release. This expensive hire should also signal the company’s desire to telegraph a much needed turnaround to stem ballooning losses. The timing was likely urgent in order to have a visible solution in place prior to announcing disappointing earnings. TearLab is likely to report a much larger loss on revenues which are flat to down. The result is expected to be a share price decline of at least 25% to around $8.50 or below. The hiring of Mr. Jensen will be positioned as a means of addressing these problems going forward. On the earnings call he will certainly announce the company’s plans for reducing the ballooning losses.

Background information

Lately I have done quite well on several trades by aggregating information from non-market sources ahead of earnings releases and placing my bets accordingly. There is nothing illegal about this. Information which can be obtained by customers, suppliers and competitors is all fair game as long as it is not supplied by company insiders. As described below, Tesla (TSLA) follower Craig Froehle recently conducted similar analysis right ahead of the $25 plunge at that company.

In August, I wrote an article just before the release of earnings at Francesca Holdings (FRAN) which predicted that an earnings miss would lead to a 30% drop in the share price. A few days later, Francesca disappointed as predicted and the share price quickly fell from $25.00 to less than $18.00. Analysts had continued to maintain price targets as high as $38.00, so they were wrong by about 90%.

More recently, I predicted a similar 30% drop upon the release of earnings by Ignite Restaurant Group (IRG). Analysts had predicted that earnings might decline a bit, but continued to maintain price targets of around $17-18. Following the release of earnings this week, Ignite quickly traded down to below $11.99, also a nearly 30% decline from the time of my article a few days earlier.

To me, both of these trades were painfully obvious. Rather than rely upon the bullish views of sell side analysts, I turned off my computer and left my desk to conduct my own research in person. With Francesca, I visited numerous stores in various cities over the span of several months. I then called dozens more and scoured the internet for evidence of discounting. In its prior earnings call, Francesca had noted that its practice of deep discounting was coming to an end and margins would rebound accordingly. Analysts believed and repeated this view almost verbatim. But my months of research showed that the discounts were actually accelerating rather than declining. A steep earnings miss was all but guaranteed. When it was reported, the stock quickly plunged as it should.

Prior to writing about IRG, I visited and called numerous restaurants across multiple states and interviewed employees on each occasion. I also aggregated information on the availability of discounts. It was clear that the company’s turnaround strategy was failing and that traffic was falling despite heavy discounting. The combination of much lower traffic along with deep discounts meant that IRG was all but guaranteed to report a loss rather than the analyst-predicted profit for the quarter. As expected, the share price dropped to below $11.99, closing in on a new 52 week low.

This type of analysis is now becoming more widely used by a wider array of investors. Investors have come to realize that the reports and targets of sell side analysts are typically useless or downright dangerous. They are often little more than gratuitous quotes from management along with lofty share price targets which get re-raised every time the share prices rise.

Just prior to the release of Q3 earnings by Tesla, Seeking Alpha author Paulo Santos wrote an article highlighting Craig Froehle’s use of VIN number tracking to get an estimate of vehicle production and sales at Tesla Motors . Mr. Santos states that

The VIN data continues to be consistent with U.S. demand for the Model S having peaked, and indeed, it’s now consistent with that demand having already weakened substantially.

One day later, seemingly bullet proof Tesla began a plunge of more than $30. The point is that this type of grass roots analysis is becoming far more useful in predicting share prices and earnings than the reports of ever bullish sell side analysts.

An earnings miss at TearLab should now be obvious

Just one year ago, TearLab was trading at below $4. The stock has since risen as high as $15 – almost a quadruple. At its peak, TearLab hit just over half a billion in market cap.

The driver for the rise in the share price over the past year has been analyst enthusiasm over revenue growth. On a percentage basis, the revenue growth has in fact been quite large, in the range of triple digit percentages. But this is simply due to the fact that it is growing off of a very small base of just over $1 million. The rise from a $4 share price to a $15 share price has occurred even though revenues have risen from around $1 million to just around $3.5 million. Yet the quarterly loss has increased from $2 million to over $12 million.

Recently the stock has been trending down towards $10 in advance of the upcoming earnings release. The reason should become apparent.

TearLab most recently reported revenues of just $3.5 million, up by $1 million from the previous quarter. But its net loss ballooned from $8 million to $12 million in a single quarter. The problem is clear. In order to increase revenues by just $1 million, TearLab must incur a massively disproportionate increase in its net loss.

Over the past few quarters, this revenue trend has looked as follows:

(click to enlarge)

Analysts have been operating under the theory that at some point TearLab will end up generating enough revenue to break through the losses. But it should be kept in mind that the TearLab product has been on the market for over 5 years and significant sales have yet to materialize. The recent growth of $1-2 million in sales has been largely the result of a sharp increase in marketing spend. The result of the heavy spending has been the steep surge in losses.

This might be an acceptable strategy if it was one that led to a sustained increase in revenues in the long run. But with TearLab, it appears that the marketing spend is often successful only in getting doctors to agree to an initial test of the system for a limited period of time. When they fail to continue using it, it means that the marketing spend is largely wasted and the revenues evaporate. TearLab then continues with its marketing spend in an attempt to get more new doctors to conduct an initial rest of the system.

TearLab’s most recent earnings call was very brief. The company reported record revenues of over $3 million in a quarter, but the company lost over $12 million for the quarter. As a result, the company has already lost more in 1H 2013 than it did for full year 2012, its previous worst year ever.

The revenue vs. net loss for TearLab over the past 4 years is as follows. (The last column on the right is YTD 2013).

(click to enlarge)

Instead of discussing the earnings miss directly, the majority of the earnings call was spent hearing a panel of hand selected experts offer their praise for the TearLab system. Of the 4 individuals, 3 were eye doctors while 1 was the CEO of the OCLI eye practice.

At the risk of stating the obvious, it should come as no surprise that the panel of 4 which were hand selected by TearLab had very positive things to say about the product. Among the doctors, some of them had been long term TearLab supporters going back for multiple years. For example, Dr. Marguerite MacDonald is featured in TearLab’s investor presentation and has served as a TearLab promoter for several years (as seen here on YouTube in 2011). Her support for TearLab has been unwavering, but it sheds little light upon the adoption of the product by newer doctors who are not dry eye aficionados.

A much more instructive approach is to contact a wider assortment of doctors’ offices who are familiar with the product and get their review. In order to achieve this, one can simply call the numbers listed on TearLab’s website under “Find a Doctor“. When prompted for location, simply click “view all locations“. A convenient list of all TearLab customers (along with their phone numbers) then appears.

Over the past few weeks, I have contacted dozens of these doctors to ask about their recommendations for conducting a dry eye exam. I did not discuss any interest in TearLab as an investment.

As would be expected, there are a large number of doctors from TearLab’s list who do recommend a tear test. What does come as a surprise though, is that there are also a large number of doctors who have received the test over the course of the past year but no longer offer it, citing lack of need, inaccuracy or difficulty in getting reimbursed.

The doctors who do not recommend TearLab’s test end up recommending the more standard Schirmer test which has been used for many years along with a simple verbal assessment.

In fact, this should not come as a surprise. After more than 5 years, use of TearLab’s test is still the vast exception to the rule. Healthcare sites such as theMayo Clinic do not mention TearLab’s tear osmolarity test at all. Instead they recommend the Schirmer test or simple verbal assessment.

The list of doctors on TearLab’s website can be somewhat difficult to track. During the course of my research, there were a number of additions to the list, representing new doctors who appear to have been added in recent weeks. But there were also some deletions representing doctors who must have either returned or abandoned the test.

TearLab had previously noted that less than 5% of doctors have ever returned a test to TearLab. However this does not account for the units which have simply been discontinued in the practices of eye doctors nor does it account for doctors who have a test unit but see no reason to use it over verbal assessment which is easier and free and is not time consuming for the busy doctors.

The point from this is that the effect of TearLab’s marketing spend often appears to be only in getting some doctors to try the test for an initial and limited period. This clearly leads to a short term rise in revenue, but also a disproportionately large increase in marketing expense. When the revenue is only short lived, this becomes highly problematic. This is likely what we have been seeing over the past 5 quarters and it explains the slight rises in revenues along with much larger increases in the net loss at TearLab. TearLab appears to be constantly in search of new doctors to replace the ones who will not adopt the test after using it.

Looking at TearLab’s product

A heavy marketing budget can drive sales of virtually any product for short periods of time. But ultimately a product will need to justify itself if it is going to sell on its own.

The biggest problem with TearLab’s product is that is just isn’t necessary for the majority of eye doctors. It is certainly true that the product is well liked by specific dry eye specialists (such as those on TearLab’s last earnings call).

The TearLab test allows doctors to quantify tear levels with a numerical score. This is why the true dry eye only specialist practitioners like it. But for the regular eye practitioner, this level of information is simply superfluous and is certainly not worth paying for or taking the extra time from other waiting patients.

In most cases, doctors will simply ask their patients to describe their symptoms and then prescribe corrective measures accordingly. This is not only faster, but it is also free. It also addresses the problem to the satisfaction of the patient.

In some cases, doctors will use the industry standard Schirmer test.

The TearLab test does not offer the majority of practitioners any useable new information. Either a patient has a condition worthy of treatment, or they do not. This is primarily based on level of discomfort. The numeric score does not really add much additional value in a practical setting.

In addition, because the test costs less that $30, there is very little revenue potential for the eye doctor. As a result there is neither an overwhelming financial or medical incentive to use this test. It simply consumes time from office visits along with space on the desk for the TearLab unit.

This is why the test which has been around for more than 5 years still only shows a few million dollars in sales and why these sales only tend to increase when accompanied by a disproportionate marketing spend.

TearLab’s method of dry eye testing has been described as the “new gold standard” for dry eye testing since the early 1990’s – nearly 20 years. It is by no means a new technology waiting for widespread adoption.

In addition, TearLab continues to cite a whopping $1.5 billion market potentialfor the product based on hoped for sales to an estimated 50,000 eye doctors in the US. This massive market potential claim has been consistent for years. Yet after all of this time, new product sales continue to measure in just the hundreds of units for the entire year. The device simply doesn’t sell even after 5 years of marketing.

By this measure, use of TearLab’s test accounts for roughly 2% of applicable dry eye tests per year. And it should be remembered that even this low level is only the result of a very heavy marketing spend.

In effect, the heavy marketing spend has resulted in a small number of doctors trying the test for limited periods of time. But over the past 5 years, there has been no consistent adoption of the test at a meaningful level. While marketing spend may get doctors to try the test, it does not get them to continue using it. As a result, TearLab is on a never ending search for more new trial doctors.

The hiring of Seph Jensen

On October 1st, TearLab announced the hiring of Seph Jensen from Alcon Labs where he had previously served as Head of Surgical Marketing. The announcement quickly sent the stock soaring to as high as $12.33. Since that time, the stock has now retreated by around 15%, giving up most of its gains.

The reason for the quick jump in the share price was obvious. At Alcon Mr. Jensen oversaw $1.4 billion in sales. If tiny TearLab with just a few million in sales could attract this type of talent, then the company must be really headed in the right direction.

Unfortunately there also appears to be a very different explanation for the timing of this hire.

Mr. Jensen was set to start with TearLab on October 31st, just two weeks before earnings are to be announced. It is very likely that the company will report a large earnings miss. Hiring Mr. Jensen will not help to explain the miss which just happened. However, it will allow the company to show shareholders that it is attempting to do something to slow the ever increasing losses.

This view is supported by the fact that Mr. Jensen’s compensation package wasastronomical for such a small company with minimal revenues and ongoing losses. Mr. Jensen will receive a base salary of $370,000 which is moderate. But he will also receive up to an additional 50% of this amount as an annual bonus. He also gets a signing bonus of $250,000. So the initial payments amount to just under $1 million. However, he was also granted 300,000 shares worth of options with a staggering 10 year maturity. The value of these options alone is worth well over $2-3 million alone. For reference, even short dated 1 year at-the-money options on TearLab are worth around $2.50 per share at present.

All in all, the pay package awarded to Mr. Jensen is worth somewhere between $2-4 million at minimum, which is in line with a full quarter’s entire revenue for the entire company. For reference, the entire SG&A expense for Q1 was only $3.9 million. Yet a similar amount is now being awarded to a single executive. The point is that Mr. Jensen should be viewed as an extremely expensive hire for TearLab.

The timing of this very expensive hire coming just before earnings suggests that TearLab is looking to provide investors with some level of comfort in the face of another quarter of ballooning losses. In any event, there is nothing out there to suggest that there has been any change leading into this quarter which will stem the pace of the accelerating consecutive losses from past quarters.


In recent cases, aggregating non-market information helped me accurately predict a significant earnings miss which presaged a quick share price decline of around 30% in several stocks.

Prior to the release of earnings for Francesca and Ignite Restaurant Group, I came to the conclusion that an earnings miss was highly likely in each case. I came to this conclusion based on dozens of phone calls and in person visits which revealed that business was not going to live up to the highly bullish expectations of analysts who cover the stock. The on the ground information I obtained was far more useful that the reports from analysts which simply repeated the views of management.

Making dozens of visits and phone calls is far from a scientific approach, but it has proven to be consistently useful to me.

With TearLab, I have called dozens of eye doctors to ask about their use of the TearLab product. I specifically called the doctors who are currently (or were previously) listed on the TearLab web site as carrying the TearLab test.

While there are naturally a large number of doctors who do carry this test, there are also a surprisingly large number of doctors who had previously used the test but who no longer recommend it to prospective patients. Even among the doctors who do carry it, they do not necessarily state that it is part of their standard dry eye exam. The Schirmer test and verbal assessment tend to remain the standard even among many TearLab customers.

The conclusion from this is that the revenue gains from TearLab’s expensive marketing efforts in some cases end up being very short lived. In many cases the doctors noted that there were several options for evaluating dry eye conditions. But in only a few cases did the doctors immediately tell me that the TearLab solution was a must.

The conclusion I have reached is that TearLab is likely to once again show a very large increase in marketing spend which will be accompanied by revenues which are either flat to down. This is simply due to a relatively underwhelming adoption of the tear test despite the heavy marketing spend. The result will be a loss which is larger than last quarter and which is moderately to significantly larger than expected by the street.

Mr. Jensen will then be given the stage to explain how things are about to change in coming quarters.

I am expecting TearLab to fall to around $8.00-$8.50 following earnings, with potential for further downside in the weeks that follow.

In the meantime, TearLab is a company which sports a $350 million market cap despite cumulative revenues of just $15 million over the past 5 years running. During this time, cumulative losses are now approaching $50 million without a single profit, with losses continuing to grow each quarter.

Disclosure: I am short TEAR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

IRG: Watch for a big earnings miss

Investment thesis

Restaurant stocks have been going through a very tough earnings season. Of the six restaurant groups to have reported so far, five have reported earnings misses. As a result, there has been significant share price weakness following earnings at companies such as Ruby Tuesday’s (RT), Darden Restaurants (DRI) and Dominoes Pizza (DPZ).

Ignite Restaurant Group (IRG) is on deck to report earnings and all signs point to a significant earnings miss. The shares have traded flat for 2 months and could see a decline of around 30%. Given the abundance of data points coming from all angles, this should not come as a surprise to anyone. A large sale by the backing private equity fund could also contribute to further pressure.


Back in August, I made an earnings call just ahead of the reporting date for Francesca Holdings (FRAN). I predicted that the clothing retailer would report weak same store sales and that discounting would continue to pressure margins. My share price target called for a quick 30% drop. Within days, Francesca’s reported their results and they were exactly as predicted. Discounting had accelerated and margins had come under pressure. The shares quickly dropped by 30% to around $17.00.

In fact, these predictions were fairly easy to make. Most of Francesca’s competitors had already reported difficult results and their share prices had tumbled. Many of these competitors even operate in the same malls as Francesca’s such that they suffered from the same weak traffic. I also made it a point to visit in person and call numerous Francesca stores over a period of many weeks so that I had a solid idea about the discounting practices in place during the quarter. My article made all of this clear.

In short, no one should have been surprised by Francesca’s poor results. But the analysts were clearly surprised. They maintained their targets at over $30.00, only lowering them after the big miss. Clearly this helps no one. For some reason, they saw no need to conduct store visits and interviews to support their targets. Likewise, we can see that many investors were also surprised. These investors have just begun filing class action lawsuits against management for not revealing the discounting practices which I described in my article before the miss was reported.

Looking at the restaurant space, we can see a very similar phenomenon unfolding. It is now easy to see that the biggest loser in the near term is going to be Ignite Restaurant Group which is likely to decline by at least 30% following earnings next week. The company is suffering from 3 years of continuously declining sales at its recently acquired Macaroni Grill. These declines are now accelerating rather than reversing. Majority shareholder JH Whitney currently owns 68% of Ignite. However a registration statement filed in July now covers the sale of these shares. The timing for such a sale looks very good for Whitney. But it will certainly put heavy pressure on the share price.

According to its latest 10Q, Ignite is now down to just $1 million in cash. Current liabilities are $106 million vs. current assets of just $40 million. The company now has long term debt of $93 million plus another $13 million due within 12 months. For all of 2013 and 2012, cash from investing activities has more than consumed all cash generated by the business as the company tries to expand its way into profitability. However the company has been losing money in two of the past three quarters. In the one profitable quarter, net income was just $2 million on $118 million in sales.

The company still suffers from multiple weaknesses in internal controls which resulted in the restatement of several years of financial results. Following a plunge in the stock, there are still shareholder lawsuits outstanding. For these reasons, Ignite is among the weakest and most vulnerable of all of the restaurant groups.

As I did with Francesca’s, I recently called and visited numerous Macaroni Grills across two states. Interviews with staff there consistently revealed the existence of significant discounting along with fairly slow traffic over the past 6-10 weeks. The results of these interviews are just one of the reasons that I expect revenues to be flat to down with significant pressure on margins resulting in a noticeable net loss.

A second reason is that we can already see that most of Ignite’s close competitors have been pummeled by poor results. The significant and persistent slowdown in the casual dining space should now be widely known. This was identical to the disappointing results reported by competitors in advance of Francesca’s. Yet many investors ignored these obvious signs and only sold after the disappointment and plunge.

Ruby Tuesday’s is down by 25% in the past few weeks following difficult results and a poor outlook for its turnaround strategy. Darden Restaurants also took a hit of 10-15% following its weak earnings. Darden operates a number of casual dining chains including Red Lobster and Olive Garden.

Shares of BJs Restaurants (BJRI) are down by nearly 30% since its last earnings date. Shares of Del Frisco’s (DFRI) are down by nearly 20%. Shares of Brinker International (EAT) are down by more than 12% since August.

Even Dominos Pizza recently skidded when it missed earnings. Dominoes is at the low end of the price spectrum such that it is usually expected to be more resistant to sector wide slowdowns than many other competitors.

The only competitor to have done well this season has been Wall Street darling Chipotle Mexican Grill (CMG). Chipotle continues to be a very strong stock that seems capable of doing no wrong.

In short, the environment for casual dining stocks has been consistently bad for most direct competitors. It should be noted that the majority of these competitors can often be found within close proximity near the same shopping malls and office complexes. As a result, their sales performances tend to be highly correlated.

Shares of Ignite have been basically flat over the past two months. However, volume has been low. This has been the case despite the fact that the problems at Ignite will have a noticeably greater impact than those of its competitors.

In its last quarterly earnings announcement, Ignite disclosed a loss of $2.5 million. Revenues had jumped to $228 million, but these were driven mostly by its recent acquisition of Romano’s Macaroni Grill in April for $61 million.

By looking deeper, we can see that growth for Ignite’s core business (which excludes the Macaroni acquisition) has basically stagnated. The revenues for Ignite have historically been dominated by its Joe’s Crab Shack chain. In its most recent quarter, revenue from Joe’s increased just 0.7%. Revenue from its Brick House Tavern chain did increase by an impressive 6%. However, given that Brick House now contributes less than 5% of revenue to Ignite (only 16 stores out of over 300), this increase does not move the needle much at all.

In order to combat the revenue stagnation at Joe’s, management plans to open up to seven new Joe’s locations during all of 2013. But obviously these new revenues will come with a fairly substantial startup cost and ramp up time so it will take some time before results are felt. It will also take time to evaluate the real cost-benefit of those new, incremental revenues.

The biggest disappointment this last quarter came from the Macaroni acquisition. Romano’s Macaroni Grill has been struggling for years, reportingsequential declines in each year going back to 2010. The struggles appear to be getting more severe and more expensive.

On its earnings call, management made some troubling revelations:

During the due diligence phase of our acquisition and right up to the February 6, signing of the letter of intent, Macaroni Grill’s comp sales were right around innegative 5%; from February through April 9, when we closed on the business, comp sales deteriorated to a negative 11.5%. While there was no secrete to us that Macaroni Grill sales had been challenged for an extended period of time, the pace of deterioration in the first quarter was significantly greaterthan we had anticipated, and we felt that we needed to act very quickly.

Management noted that it completed a $2 million media buy to attempt to boost sales. This did help to slow the decline moderately. But in the end, Macaroni Grill sales still decreased by 7.4% vs. the prior year. And it should be noted that even this dubious victory still cost management $2 million which went straight to the bottom line.

These observations reveal two significant problems which are going to drive the earnings miss and share price decline at Ignite.

The Macaroni Grill now dominates the equation for Ignite. As of June 30th, there were 186 Macaroni Grills, 134 Joe’s Crab Shacks and just 16 Brick House Taverns.

The decision to substantially lever up to acquire the declining Macaroni Grill is a questionable one. Revenue from the chain was already in decline in each of the past 3 years. It has already declined by nearly 30% in that time. This was prior to the declines in 2013 which now appear to be accelerating.

In 2012, Macaroni lost $6 million on $390 million in sales. Sales are already on track to decline a further 25% from that level this year, following a 10% decline the previous year. Nothing seems to be able to slow the decline.

Management seems to indicate that the problems at Macaroni were larger and more expensive than they had expected. They have also admitted that they were “overconfident” in their ability to make a rapid turnaround of the chain. In effect, we have already been warned of what to expect from management.

The Macaroni restaurants were being staffed very lightly to deal with ongoing declines in business. But new management hopes to ramp up business, and therefore chose to increase headcount by 1,700 jobs. Management noted that:

At any rate a significant investment was made and clearly more than we have planned.

But here is the biggest problem. In order to maintain any type of longer term profitability, Ignite simply must effect a successful turnaround of Macaroni. But turnarounds take lots of time and lots of money before the results are felt or known. It is almost a certainty that the next 2-3 quarters (including this one) are going to be dominated by substantial turnaround expenses from Macaroni. If the turnaround works, we will then likely see results in mid 2014. But until that time there will be lots of pain in advance of the hoped for gain. It also remains to be seen if the surge in expenditures for a few quarters will end up creating a sustained boost to the results of the chain once deep discounting comes to an end.

Management has already committed itself to substantial fixed costs by adding these 1,700 new jobs. Many of the hires would not have been in place for the full length of last quarter. As a result, the expensive effect of these hires on net income will not be fully felt until this quarter. Management will also continue to spend heavily on media buys and the advertising budget. But as we saw last quarter, even spending $2 million did not end up increasing sales. It only slowed the rate of decline.

Perhaps the largest negative impact will come from the discounting of customer bills that is necessary in order to attempt to lure customers in to the stores. We can see from their website that there are multiple promotions ongoing which promise discounts to customers. Sales of alcohol are a leading profit driver for these chains. But Macaroni is now offering half priced wine priced at just $2.75 to attract customers. Visitors are offered $5 off for signing up for the mailing list. Group parties who pre-book get 15% off. Each time I ate at Macaroni Grill, the staff gave me discount coupons to come back again and get more taken off of my bill. It is clear that Macaroni Grill is trying to increase absolute traffic by cutting prices wherever possible.

According to the wait staff I spoke with, a new line of bigger promotions will be rolled out this weekend. Those who wish to gauge the impact of future discounts should check on Ignite’s website once these promotions are announced over the weekend.

But we can see from past promotions that these discounts have previously failed to boost sales. Coupon histories can still be found online which show that during late 2012 and early 2013 Macaroni Grill was providing half priced food and “buy one get one free” offers. These offers were made at precisely the time that sales for Macaroni Grill were showing their largest declines.

These offers are a devils bargain for restaurants. They often end up losing money on them, but they feel that they have no other choice if they want to stimulate the nominal level of sales and traffic.

During the most recent quarter, the Macaroni Grill returned to “buy one get one free” promotions. “Happy hour” with loss leading specials now lasts as long as 5 hours. This leaves very few prime time hours during which to offset those losses.

What we will almost certainly see at earnings is that the heavy spending and discounting will help to move the needle on revenues, but it will come at an enormous cost to margins and will contribute to a large net loss.

Given the accelerated discounting, it is almost guaranteed that the net loss in the current quarter will greatly exceed the $2.5 million from last quarter. In fact, the loss could even significantly exceed the $8 million loss reported in December of 2012.

Heavy discounting to stimulate declining traffic was exactly what we saw in the retail space with Francesca’s which led to its recent 30% plunge. The malaise is also identical to what we saw with the turnaround strategy at Ruby Tuesday’s. By now, the short term results of this type of strategy should be predictable. Investors will be forced to tolerate near term losses in the hopes that a rebound will happen in several quarters. But in fact, most investors will tolerate no such thing. They will tend to sell their shares now and re-evaluate once the results of the turnaround strategy become better understood in a few quarters.

Part of the problem in the restaurant industry is that these discounts have been absolutely pervasive this year. When every restaurant out there is offering deep discounts, it does little to help the business of any one of them. Instead, it just means that deep discounts are needed just to lure customers away from the other deep discounting restaurants. For those who are interested, here is just one of dozens of coupon lists where consumers can get deep discounts on meals from Applebee’s, PF Changs, Sonic, Cheesecake Factory, Olive Garden, Outback, Chili’s and on and on.

The conclusion is that many restaurants are now being forced to issue coupons and discounts. If they do not, customers will simply go to other chains which have large discounts. And when one restaurant stops discounting, consumers will just switch to the others that do. In the current environment, no one should be paying anything close to full price for meals in casual dining chains.

Share of Ruby Tuesday’s fell by 16% upon earnings. Stifel Nicholas describedthe situation for the brand in a research report as follows (readers should note that these comments appear to apply quite precisely to Ignite and other brands as well).

The persistent casual-dining sales slowdown has presented a more-than-challenging environment for an in-turnaround concept such as Ruby Tuesday that seeks to re-introduce consumers to its brand,” he said. “We continue to believe that mass-casual family dining names such as Ruby Tuesday willcontinue to underperform until the casual-dining sales softness that haspersisted throughout September shows signs of reversal.

So we now have the observations from above, along with statements from management and then comments from analysts. All of these consistently point to a very challenging environment for the comps and especially for turnaround stories like Ignite.

After viewing these similar assessments, no one has any excuse whatsoever to be surprised at a substantial disappointment from Ignite next week.

One question now is whether or not private equity firm JH Whitney intends to stick around for several more quarters to see if this acquisition can actually be turned around. The recent registration statement was filed in July. This was just a few months after the troubled Macaroni acquisition and just before the recent earnings disappointment was made known to investors. Whitney has two board seats at Ignite, so it should be fairly plugged in to the latest developments.

Whitney has already done well with this investment. The firm sold stock in the IPO at $14.00 and also received an $80 million cash dividend payment from Ignite before the IPO.

The acquisition of Macaroni has some interesting details. The target was acquired from Golden Gate Capital for $61 million in cash. Whitney and Golden Gate have some intertwined executive histories and they have also worked together in the past, most notably in taking Herbalife (HLF) private and then selling the company for a substantial profit.

The Los Angeles Times notes that

Whitney and San Francisco-based investment firm Golden Gate Capital Inc. acquired Herbalife for $700 million in 2002, putting up $176 million of their own money.

Shortly after the firm went public again in late 2004, it paid Whitney andGolden Gatemore than $110 million in dividends, filings show.

After the value of the shares more than doubled in 2005, Whitney sold a large portion of its holdings, raising $233 million.

In the case of Ignite, JH Whitney’s rush to get liquidity in the stock means it may have come public a bit before it actually was ready to be an answerable public company.

Ignite still lists 4 material weaknesses in its internal accounting controls. Previous weaknesses resulted in Ignite restating 3 years worth of financial statements just after the company came public. This caused a 25% plunge in the share price and resulted in lawsuits against the company and their underwriter for making material misstatements in the IPO.

It is somewhat surprising that the weaknesses have still not been remedied even 15 months after the IPO. Instead, the company has taken a JOBS Act exemption which allows it to continue operating with material weaknesses in internal controls. Under normal circumstances, this would be bad enough. But with Ignite trying to integrate a major acquisition of a very challenged and sprawling brand, this is almost a perfect formula for yet another restatement.


Right now is a great time for consumers who wish to eat out cheaply. Restaurants are aggressively competing on price to combat a sector-wide slowdown in traffic. These restaurants have demonstrated that they are more than willing to incur substantial losses in an attempt to maintain traffic. We have already seen earnings disappointments in 5 out of 6 reporting restaurants. Share prices have dropped accordingly. So what turns out to be great for consumers is in fact quite challenging to these restaurant groups.

Ignite is a far weaker restaurant group than most of its peers. The company’s balance sheet is very weak with just $1 million in cash and a deep current account deficit. The company has reported losses in two of the past three quarters. Last quarter began to feel the impact of the continued slowdown in the Macaroni Grill. Efforts to stem the decline are already proving to be very expensive but with minimal results. Management clearly has its hands very full in trying to integrate this large acquisition, such that ineffective internal controls have still not been remedied after 15 months.

Ignite and several analysts have already given us a very clear view about what to expect this quarter in terms of the restaurant slowdown and the impact on revenues and earnings. By trying to launch an expensive turnaround during a restaurant slowdown, Ignite is likely to exacerbate these difficulties substantially.

As a result, no one should be even remotely surprised when Ignite reports a much larger loss than last quarter. Shares should be expected to correct by around 30% to around $11-12 following earnings.

Disclosure: I am short IRG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.


Kandi: The truth hurts

As I mentioned in my last article, Kandi Technologies (KNDI) recently soared from around $5.00 to a lifetime high of $9.20 in the span of just 8 days. Just like in June, this monumental lift off came as the result of a single press release from Kandi and several promotional articles from individuals who are long the stock.

As has been the case in every instance in Kandi’s past, these gains have not held. Kandi has now declined 5 days in a row to $7.10, a very rapid decline of 23% from that recent high just days ago. Yesterday the stock closed near the day’s low of $7.02. If this rate of decline continues, then Kandi will be below $5.50 by the end of next week.

It is clear that many investors who are active in Kandi have derived the vast majority of their information from a series of highly bullish articles and from a private Yahoo message board which was created specifically by those who promote Kandi. The information presented seems to gain credibility because it appears to come from multiple independent sources.

Unfortunately, much of the information which has been disseminated on Kandi (and which has made the price soar) is 100% factually incorrect. Once again, as investors come to realize that they have invested based on inaccurate information, the stock will certainly erase its gains and go back below $5.00 once again.

The most recent example was the article published by Harris Goldman, entitled “As China Goes, So Goes Kandi”. His article has since been removed from Seeking Alpha. Fortunately, references to his comments can still be found in my last article.

The Goldman article does not appear to be the only bull piece that contains substantial inaccuracies which have boosted the share price. Going forward, I will be releasing a series of corrections to a number of very significant factual inaccuracies which have boosted Kandi’s share price in recent articles. This work is already in progress.

Unfortunately I did not save a PDF hard copy of the Goldman article, so we do not have a full permanent record of the line by line comments. However, I have now downloaded and saved copies of all remaining articles relating to Kandi so as to preserve a permanent record in the future

To be specific, Kandi bulls have misled readers about numerous things including: Kandi’s manufacturing capabilities, Kandi’s competitors, the current market demand for EVs in China and the impact of government subsidies.

On the day before the publication of the Goldman article, Kandi had traded as low as $6.60. On the day of his article, the stock rose as high as $8.60. Within 2 days, the stock hit its all time high of $9.20. This was a rise of nearly 40% in just 2 days, based off of a single article.

There is a very clear reason why the Goldman article (as with some of the others) moved the stock. Mr. Goldman made it clear that Kandi is the ONLY company which has mass capabilities and that NO ONE other than Kandi in China can compete on this type of price and volume. Mr. Goldman had incorrectly noted that Kandi already has capacity of 100,000 vehicles which will increase to 300,000.

If any of this were true, Kandi would have certainly deserved a bump up in its share price. In fact, it might actually lend some credence to the notion that Kandi is “the Tesla of China“. Unfortunately none of these statements are correct.

Fact: The EV market in China suffers from too much capacity and too little demand

The Kandi bulls have promoted the view that Kandi is the ONLY competitor in China and that demand is so strong that Kandi will be able to sell everything it can produce.

These statements are both 100% incorrect. There are hundreds of EV manufacturers in China. These are not tiny no-name companies. And they already have greater manufacturing capacity than Kandi. In addition, the prices for their EVs can be seen to be lower than Kandi’s. Their operational specs are basically identical.

In my last article, I included a link to a search on China’s Alibaba portal (in English) which showed these hundreds of competitors. But clearly from the angry emails and comments that have been written, we can see that almost no one even bothered to open the links and read for themselves. Instead, a small number of vocal Kandi bulls simply rejected my findings without even reading them.

I would strongly suggest that readers not simply rely on an interpretation of this list from either me (I am short Kandi) or from Art Porcari (Art is long Kandi). Instead, I would suggest that readers take a small amount of time to evaluate these competitors themselves.

What they will see is that there are many producers of roadworthy and street legal vehicles which derive the vast majority of their sales from entirely within China. Period.

Below is a very brief and partial selection from my Alibaba list, along with their delivery capacities. As we can see, there are numerous manufacturers in China who have greater manufacturing capacities AND lower prices than Kandi. I have included the link to the individual vehicle listings so that viewers can see for themselves that these are mostly identical to Kandi’s cars. Beyond these, there are many more.


Name Annual Capacity City Price
Zhangjiagang Haowin New Energy Technology Co. 120,000 Shanghai Inquire at Alibaba
Jinan Qingong International Trade Co. 104,000 Qingdao $6,400-$8,600
Guangfeng Xiaoni Trading Im. And Ex. Co. 96,000 Tianjin $3,500-$4000
Guangdong Yatian Industrial Co. 72,000 Guangzhou $7,000-$7,650
Shandong Bidewen Power Technology Co. 60,000 Qingdao Inquire at Alibaba
Shangdog Shifeng Co. 50,000 Qingdao Inquire at Alibaba
Shandong Wina Green Power Co. 50,000 Shangdong Inquire at Alibaba
Jinan Allied International Trading Co. 30,000 Qingdao $8,000-$9,000

Until my recent article, Kandi’s promoters continued to make the claim that Kandi is the ONLY such manufacturer in China simply because US investors did not know otherwise. Of the EV makers that sell in China almost none of these companies trade on US stock exchanges. The only ones that do (such as BYD and Geely) tend to be Hong Kong listed and trade on the pink sheets. The EV makers in China typically market themselves only in China. As a result, the vast majority of US investors are entirely unaware of the presence of numerous competitors.

But the Kandi promoters have repeatedly claimed to have performed countless hours of “due diligence” over the span of multiple years. The words “due diligence” appear numerous times throughout their articles as assurance to readers about the thoroughness of their work.

Yet the information on competitors is easy to find for anyone who looks.

Author Tom Konrad (who was long the stock) lost a number of friends when he expressed some caution on Kandi. This was true even though he maintained a (reduced) position as a long. Unlike some of the more unrepentant bulls, Tom made sure to highlight the fact that Kandi does have competition from some of the largest EV manufacturers in China. Tom specifically highlighted Chery Automotive, Shandong Shifeng Group, and Hebei Yu Jie Ma. Tom recently noted that he sold his Kandi stock as soon as it hit $7.00.

Point #1: It is inconceivable that such thorough “due diligence” from the Kandi perma-bulls would have failed to uncover the existence of hundreds of nearly identical competitors who have massive production capacity in China. Yet until my last article, these facts were denied.

Point #2: The claim that Kandi is somehow unique (“the Tesla of China”) is therefore based on information that is 100% inaccurate. Yet this inaccurate claim has now been made dozens of times.

Clearly the points above illustrate that there supply of EVs is far greater in China than the Kandi bulls have stated. But of equal importance, it is also the case that demand is far lower than the bulls have stated.

We can see that many of the bull arguments posted include the fact that China has targeted 500,000 EVs by 2015 and 5 million by 2020. Some have cited the “10 Cities and 1,000 Vehicles” program which has been promoting EVs via subsidies in 25 cities (including HangZhou). This program which includes subsidies has been in place since 2009.

The Kandi promoters have emphasized these impressive facts to indicate that there will be tremendous demand for EVs in China. This information, coupled with the incorrect information that only Kandi can supply them, has led investors to the conclusion that Kandi will soon be worth a tremendous fortune. People who read the bullish articles on these subjects, but who fail to do their own research, are then fully convinced. When the articles come from multiple authors, it lends even greater credibility.

But the reality for Kandi and for the EV market in China is far different than what is being consistently preached by the Kandi promoters. In fact, the reality is entirely consistent with the results we see from Kandi’s financial statements. It is also consistent with the share price reactions we have seen from the few Chinese EV makers who trade on foreign exchanges. It is also quite consistent with the unanimous view expressed by independent media channels and Chinese automotive experts.

The only people telling us otherwise are a small number of individuals who happen to own Kandi stock.

In July of 2013 (just 3 months ago), the WorldWatch institute put out a research piece entitled: “China’s Electric Vehicle Development Failing to Meet Ambitious Targets”

The report states clearly that

Although these ambitious targets are developed and supported by the central government, they seem overly optimistic and unattainable given the current situation. According to the China Association of Automobile Manufacturers, only about 20,000 new energy vehicles (EVs, hybrid-electric vehicles (HEVs), and PHEVs combined) were sold in 2011 and 2012, meeting only 4 percent of the 2015 target.

The current reality in China is that people aren’t buying electric vehicles simply because they don’t want them. Clearly some of this is related to price. The bulls have stated clearly that the recently announced subsidies will help that.

But the recent subsidies were actually a renewal of subsidies that have been in place for years. During that time, and despite the subsidies, EV sales have been miniscule.

According to a report from McKinsey.

Government-sponsored subsidies have failed to stimulate consumer demand. For example, while EV buyers in Shenzhen were offered some of the highest subsidies in the country (e.g. RMB 120,000 per vehicle for BEV passenger cars), automakers sold only about 600 BEVs there by 2011.

Beijing based Jack Perkowski has over two decades of experience as an expert in China’s auto industry. He formerly ran a joint venture which invested over $100 million in Chinese auto parts JVs. In June 2013, Mr. Perkowski wrote an article in Forbes entitled “The Reality Of Electric Cars In China“.

He notes that:

recent meetings that we have had with most of China’s local car assemblers confirm that none are counting on electric vehicles for any meaningful amount of growth anytime soon…. BYD , the poster child for electric vehicles in China, is also de-emphasizing electric vehicles. … Due to their intellectual appeal, hype for electric vehicles has always gotten ahead of the realities of market demand. In China, this is once again proving to be true. just put out an article last week in response to the latest Chinese subsidy news entitled “Even the Chinese government can’t command progress on electric cars“.

According to Quartz:

Beijing hasn’t given up on the race to dominate electric cars. But scant sales have turned China away from focusing on wheels on the road right now….About three years ago, the US and China both announced ambitious aims to capture the global electric car market by putting, respectively, 1 million and 500,000 electrified vehicles on their roads by 2015. Today, neither country is on track to reach these numbers-instead, the US has 130,000 electrics andChina a paltry 40,000…. But analysts doubt the renewed subsidies will finally trigger a buying binge

Those who are reading this article can feel free to completely disregard my views. After all, I am short the stock and therefore biased. However…

Point #3 : US investors need to ask themselves why so many independent experts such as Bloomberg, McKinsey, WorldWatch, Perkowski and Quartz, are all so bearish on the EV market in China. Likewise, they need to ask themselves why the only parties who are wildly bullish happen to be a small handful of investors who also happen to own stock in Kandi ?

There are a number of very common sense and logical reasons why EV sales continue to be so poor in China. For these same reasons, most experts do not see a substantial rise in EV sales any time soon.

Because these EV makers have competed on price, the quality of the vehicles is undeniably very low. This should be visible from the pictures of Kandi’s cars which are available on line. The dozens of competing low speed, low priced vehicles are also nearly identical.

The drive train for an electric vehicle is actually fairly pricey. Yet the cost of the whole vehicle is only around $10,000. Readers need to use their common sense to decide if one can actually manufacture a high quality automobile for just a few thousand dollars.

I recently test drove a Kandi vehicle which sold for around $10,000. It was not horrible, but quality was clearly an issue. When I drove it, the glove box kept falling open. The windows are old fashioned crank style windows which do not open easily. The seats vibrate a lot. There is a loud whirring noise when driving. It is not the end of the world. But it is also not a vehicle that many people would likely choose to drive – at any price – if they have any alternative.

But keep in mind that Art Porcari has also test driven a Kandi car and he continues to tell us all that Kandi is set for near term greatness. He is also long the stock and stands to benefit from the rise in its share price.

Kandi, Geely and many other manufacturers have had EVs on the market for years. The “10 Cities” program has been promoting EVs since 2009. Yet in the past two years, a grand total of only 20,000-40,000 vehicles has been sold – by all manufacturers combined ! This is during a time when the subsidies werealready in effect.

The reason why Kandi itself only sells a few hundred of these EVs is because most people are not interested in driving such a low end vehicle. We have already seen that cutting the price does not really boost sales when it is a product that people just don’t want. People need to keep in mind that the vehicles made by Kandi have absolutely nothing in common with a high end vehicle like Tesla.

A separate reason is far more practical. Anyone who has lived in China knows that parking in any major city in China is very similar to trying to park in the middle of Manhattan – or worse. It is extremely difficult and absurdly expensive. This should be intuitive when one considers that the population of Beijing is over 20 million. The population of Shanghai is over 40 million. That means that the population of Shanghai is greater than the entire state of California – crammed into a single city. It is greater than the population of New York, Los Angeles, Chicago, San Francisco Boston and Seattle – combined ! And that is just one city. Likewise, China has dozens of cities with populations greater than 5 million.

What is the point ? The point is that people who can’t afford $10,000 for a car can also not afford to drive or park a car at any price in China. Many US investors are clearly unaware that in a country of 1.6 billion people, the vast majority of people do not live in single family homes with an attached garage. They live in large high rise buildings which do not come with their own garage space. If you gave them an EV for free, they would still have no place to park it. Nowhere !

Those who can afford a home with a garage in China are typically not inclined to buy a noisy low speed vehicle with crank windows and no amenities. Those who cannot afford a garage have no interest in owning a car at all.

These notions are not my opinions. They are facts which are frequently expressed in the Chinese media. One example can be found in an article entitled:

Dying for a Spot: China’s car ownership growth is driving a national parking space shortage

Individual readers can come up with their own explanations for the very poor EV sales. But the fact remains that there has been virtually no demand for low priced, low speed EVs in China from consumers.

I am not saying that Kandi will not sell any vehicles. I am saying the best case scenario is dramatically less than what the Kandi bulls are promoting. It is clear that Kandi and the dozens of other major EV makers will hope to sell the low cost, low speed vehicles to taxi and other public transportation systems.

WorldWatch agrees with this, saying:

As a result, more than 80 percent of the so-called “energy-saving and new-energy vehicles” (EVs, HEVs, PHEVs, fuel cell vehicles, and other energy-saving conventional vehicles)across the 25 pilot cities were purchased for public transportation service rather than private use, showing a weak market demand for these types of vehicles among private consumers.

Likewise, McKinsey shares this view, stating:

In addition, government subsidies and incentive policies have proven to be far more effective at stimulating the purchase of EVs for public fleets than they have been at stimulating private consumer demand.

The HangZhou agreement with Kandi was announced in 2012 but material sales have yet to occur. At some point in time, if material sales actually materialize, this will be a good start for Kandi. Kandi may therefore be able to sell several thousand vehicles over the next few years. But this is categorically different than the predictions of $2 billion in sales from Mr. Goldman or even $100 million in near term sales from Mr. Porcari.

While there may ultimately be demand for even more LSVs from various taxi and public transport companies across China, it must also be remembered that there are potentially hundreds of companies – with massive over capacity in production – who are vying for this same business.

Point #4: Kandi bulls have projected massive sales figures by simply assuming that demand is there for 100% of what Kandi can produce. Yet despite ongoing subsidies and incentives for the past 3 years, only 20,000-40,000 EVs have been sold across all of China by all EV makers combined.

Question: Did Kandi move due to “news” or hype ?

Whenever there is any news which applies to EVs in China, Kandi’s promoters begin trumpeting the development as being a massive catalyst for Kandi’s near term profits and share price. So far this gambit has worked well, and the share price shows sharp jumps (but which only last for a few days).

We saw this sort of hype in June when Kandi announced its inclusion on the MIIT approved vehicle list. The problem with this news is that it applied to hundreds of other vehicle manufacturers and thousands of other models. No other EV manufacturer saw their stock surge even though they were included on this list too. In fact, no one else even bothered to announce this “news” because it was a non-event. Yet Kandi’s share price quickly doubled to $8.50. It was also interesting that the official list had been published in China weeks before Kandi chose to announce it for themselves. Kandi delayed the promotion of this news until it was much closer to issuing $26 million in stock.

This latest “news” in September was that China had codified its subsidies for EVs. Again, this was trumpeted as a major and transformational development for Kandi and the stock soared to $9.20 on the back of Mr. Goldman’s article. As was the case in June, this news was released over a week earlier. Kandi did not put out a pres release on the subject until immediately before filing a S3 covering the sale of over 1 million warrants which would raise $5 million for Kandi.

As was the case in June, the September news applied to the entire EV market in China. Of greater importance is the fact that these were not new subsidies at all, but instead were just a renewal of past subsides. And in sharp contrast to the analysis from Kandi promoters (who own Kandi stock), independent media suggested that the news was not so great.

So what does the independent media have to say about the latest “news” ?

Bloomberg offered the following commentary on September 17th, following the announcement of the subsidies:

The new policy is basically the same as the previous one and doesn’t really address the underlying problems,” Han Weiqi, an analyst with CSC International Holdings Ltd. in Shanghai, said yesterday in a phone interview. “Unless there are follow-up measures to step up support for hybrids, today’s policy is not expected to spur the EV market.

A new subsidy plan has been long awaited,” Ole Hui, Hong Kong-based analyst at Mizuho Financial Group Inc. (8411), wrote in a report today. “This new plans seems less aggressive than earlier targets.

So how did the share prices of other EV makers respond to the news ? They certainly did not shoot up by 50% like Kandi did. Following the release of the subsidy news, Bloomberg noted that:

BYD Co. (1211), the maker of electric vehicles that counts Warren Buffett‘sBerkshire Hathaway Inc. (BRK/A) as a shareholder, fell as much as 3 percent as of 11:12 a.m. in Hong Kong trading.SAIC Motor Corp. (600104), which began offering its Roewe E50 electric car in November, slid as much as 1.4 percent in Shanghai.

But for the Kandi bulls, the recent “news” of Chinese subsidies was to be transformational and would send Kandi into the stratosphere.

What is the point of this ? The point is that the facts being conveyed by a small number of vocal Kandi bulls (who happen to own the stock) is wildly at odds with view being expressed by the mainstream media, including Bloomberg, McKinsey, WorldWatch and many others. The movements in the share prices of other EV makers seems to agree with Bloomberg. Only Kandi has soared to new highs. But this sharp rise has been based on the analysis and interpretation of this small group of individuals who profit from gains in Kandi’s stock.

Point #5: Even when news has been neutral or negative, Kandi bulls have used any mention of EVs in China to proclaim a new, transformational tipping point for the stock. This has consistently been at odds with the views of independent media sources and the share price reactions of the few publicly traded Chinese EV makers.


There are several realities that we must deal with in looking at Kandi.

The first reality: there are a large number of investors who simply do not even care if Kandi has a bright and legitimate future or not. They simply know that these hyper bullish articles have consistently been able to provide the stock with a sharp (but brief) boost. They are happy to buy and make a quick and easy profit. But they have no intention of waiting around to see if the hype is real. As a result, they quickly sell to lock in quick profits. This is why Kandi has repeatedly given up its gains on each surge in 2013.

It can be easily seen on comments below articles and on message boards that various investors are now counting much more on a continuing stream of bullish articles to pump up the share price than they are on any actual progress from Kandi itself. This is a very bad sign for any stock.

The second reality: The information which has been used to promote Kandi’s share price has often been 100% incorrect. Kandi is NOT the ONLY supplier of EVs in China, there are hundreds of identical offerings. Demand for EVs is not astronomical. It is not even merely substantial. The extremely and persistently low levels of demand have been cause for concern in various independent articles and industry reports. Likewise, the latest “news” regarding the EV industry and subsidies in China has been negative and has seen share prices of other Chinese EV makers fall rather than skyrocket. Analysis by independent media sources (who do not happen to own Kandi stock) have been unanimous on this front.

But because the numerous other EV competitors in China are unknown in the US, many US investors have come to believe that this inaccurate information is true. The fact that multiple writers have been posting very similar (but inaccurate) information has caused many investors to give this information even greater credence.

The fact remains that many investors who have bid up the price of Kandi by 50-100% have done so based on information which is verifiably 100% incorrect. As they come to appreciate this, the stock will almost certainly correct to below $5.00, from where it began.

The third reality: Kandi bears all the hallmarks of a classic stock promotion. A small number of investors produce well timed and coordinated articles designed to generate maximum enthusiasm for the stock. Much of the information is inaccurate. The promotion is then coordinated with organized buying to elevate the price.

The promoters of Kandi have then set very lofty share price targets which are often several hundred percent above the current level.

But readers need to ask themselves this: if Kandi is destined to rise to $30-50 in the near future, then why is there such a desperate need to continue pumping the stock when it gets down to $5.00 ? Why is there such a desperate need to defend the stock as soon as it falls by as little as 50 cents ?

If the share price were really headed to $30-50, then the right strategy would be to simply turn off ones computer and ignore the stock for the next 6-12 months. One could simply ignore arguments like mine because they would truly have no impact on the share price 6 months from now. These gyrations would be just random noise over the period of a few months.

The determination by the promoters to get the share price up basically tells us that they do not have the confidence in Kandi that they claim. Their rabid concern over the share price can only be explained by assuming that they are looking to sell in the near term and at prices not far above current levels.

Clearly the only thing that would really propel Kandi to such lofty levels would be actual success on the commercial front. But the steady stream of articles designed to pump up the share price has continued anyway. And now, we are told to expect a full promotional video produced by a professionally hired video production team. Once again, if the stock is inevitably headed for $30, then such a promo video would not be necessary. Nor would it have any marginal impact relative to the triple digit gains which are expected.

The good news is that for those who really believe that Kandi is truly destined for near term greatness, detailed findings like these really don’t matter. Investors who feel this way should simply disregard this article and not even watch the share price.

Disclosure: I am short KNDI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Biolase plunges on liquidity concerns

On Wednesday August 7th, Biolase Inc (BIOLannounced Q2 results. The company missed analyst estimates by 2 cents and updated investors with guidance at the lower end of previously given ranges.

Missing earnings is never a good thing. But as earnings misses go, this one was certainly not catastrophic. Despite the moderate nature of the miss, shares of Biolase began to plunge in the days that followed. The shares have now fallen by 50% in the week since earnings. The shares have not traded up on a single day since earnings. Clearly something bigger is going on.

(click to enlarge)

As shown below, further steep declines in Biolase are highly likely in the next few days due to the need to issue a large amount of equity, regardless of the price.

The company’s $30 million S3 registration statement should be effective within days, at which time the offering can proceed. Biolase is in a position where it simply must complete an offering, such that even if the price falls to $1.00 or below, the offering must still proceed.

What has happened is that details given in the 10Q and the earnings call have revealed that Biolase is now in the middle of a near term solvency crisis. Yesterday, as the stock was hitting $1.80 (down 50% since earnings), Biolase put out a brief press release, repeating what it had already stated in the recent 10Q, that Comerica Bank had waived Biolase’s non-compliance until September. But, as expected, the stock price was not cheered and continued to fall 7% further that day. Following the press release, Biolase closed at $1.81, a new low for the year.

As confirmed in the press release, Biolase is now in violation of its bank covenants. It has around 19 more trading days in which to rectify this situation before the Comerica deadline. Biolase has already given weak guidance for the remainder of the year such that any turnaround in financial performance will not be able to repair the situation with Comerica.

The only way for Biolase to repair the situation with its lender will be to issue a substantial amount of stock at whatever price the market will bear within the next 19 trading days. Biolase knew that this situation was coming, so they filed a $30 million S3 registration statement just a few days before earnings. Had the S3 been effective, Biolase would presumably have already issued stock immediately.

On the conference call Biolase specifically highlighted the filing of the S3 as its source of liquidity when discussing its low cash balance and the situation with its credit facility. As a result, there should be very little uncertainty with respect to the company’s intentions about issuing stock.

The $30 million S3 was filed on July 26th. Yesterday (after the close) Biolase filed the amended S3 which included reference to the latest 10Q and the latest share price. It confirmed a maximum size of $30 million. There were no other changes of substance. As a result, the S3 should be effective within a matter of days.

At that time Biolase will need to issue stock almost immediately. The biggest threat to Biolase is now that the stock will continue to fall before the offering can be completed. Either way, once the S3 is effective, we can expect a very quick offering by Biolase which will likely come with a discount of at least 20%. Given the distressed nature of the company at present, the offering will likely require additional issuance of warrants.

The market has already figured this out. This is the reason for the continuing plunge in the share price.

It doesn’t matter where the stock appears to stabilize, investors always become aware that a further drop is guaranteed because of the need to issue stock at any price. Hence, the selling continues.

Biolase has not risen on a single day since releasing earnings.

Certainly Brecken Capital saw this coming. The fund had previously owned around 9% of Biolase but began selling down its holdings following disappointing Q1 results. As soon as the S3 was filed, Brecken reduced its stake to exactly 4.99% which allows it to sell further without making any disclosures. Had Brecken attempted to dump larger amounts of stock earlier, the reported sales would have spooked other investors making additional sales difficult for Brecken. Instead, Brecken conducted a very smart stealth exit from Biolase.

Everyone knows that an offering is coming. Everyone also knows that the discount on the offering will be very large due to Biolase’s distressed financial condition. This has created a viscous circle of selling.

Now there is the additional problem that as Biolase’s share price continues to fall, the market cap is now getting dangerously low. There becomes the very real risk that Biolase will be forced to issue substantial amounts of stock at prices below $1.00. But at those prices, Biolase would struggle to raise a sufficient amount of money to satisfy the bank while continuing to run its business.

On its recent conference call, Biolase management disclosed that revenues were 7-10% lower than internal goals for the quarter. Gross margin fell from 55% to 39%. The net loss grew to $2.6 million. Cash balance has now fallen to just $2 million and management disclosed that the company will not generate cash flow for the year.

Total stockholders equity has now fallen to just $8 million. Meanwhile Biolase owes at least $6 million to Comerica.

According to the credit agreements, Comerica has the right to declare all amount outstanding to be immediately repayable in the event of a default. Biolase is now in default due to its failure to maintain $500,000 of EBITDA. But clearly Biolase does not have the money to repay Comerica.

As a result, Comerica had no choice but to waive the default for Biolase for several weeks. As an initial move, Comerica did begin curtailing credit to Biolase to restrict any future borrowing. The credit facility has just beenreduced from $10 million to $7.5 million.

Often times there are creative ways for distressed companies to gain some additional traction with their lenders during hard times. Unfortunately, Biolase appears to have already exhausted all of these extreme measures.

The receivables have already been placed in a “lock box“, such that Biolase cannot touch any of the proceeds from these sales until Comerica first receives the money and services the debt.

Next, substantially all of the assets of Biolase have been pledged. This is not just assets which are presently owned, but also against any assets which may be acquired in the future.

As disclosed by Biolase

Lockbox arrangements under the revolving bank facilities provide that substantially all of the income generated is deposited directly into lockbox accounts and then swept into cash management accounts for the benefit of Comerica Bank. Cash is disbursed from Comerica Bank to the Company only after payment of the applicable debt service and principal. At June 30, 2013 and December 31, 2012, there were no restricted cash amounts. The Company’s obligations are generally secured by substantially all of the Company’s assets now owned or hereinafter acquired.

Also disclosed was that Biolase issued 80,000 warrants to Comerica with a strike price of $2.00. This warrant would have been an incentive payment from Biolase to Comerica. The warrant was issued in 2012 and was fully exercised by Comerica in 1Q2013. The issuance of stock warrants to maintain a lending relationship with a bank is a very unique occurrence. But the issue is that stock and warrants are the only currency that Biolase can currently make use of.

What we can see is that anything resembling an asset has already been given to the bank as security. There is nothing left to give. When assets ran out, Biolase began giving the bank warrants on its stock. But with the share price is a tailspin below $2.00, there is little value left to be given to the bank.

As a result, Biolase has no choice but to issue equity at any price, regardless of how low.

How did we get here ?

Biolase has been in business for nearly 20 years but has consistently failed to generate profits.

After years of consistent losses, investors and analysts were cheered in March, when Biolase released Q4 results. In Q4 Biolase reported a rise in revenue and a very rare profit. The hope was that after decades, Biolase might finally be turning the corner. The shares rose to a multi year high of over $6.00, up from just $1.50 last year.

This hope was darkened when a disappointing Q1 was reported (including a resumption of net losses and a dangerous drop in cash). The shares quickly fell to below $4.00.

Q2 results the smashed all hopes completely. It was another money losing quarter along with discouraging guidance. Within days the stock was trading below $2.00 again.

(click to enlarge)

The ongoing net losses have been a notable drain on cash. Biolase has not shown any positive cash flow from operations in the past 4 years. The only source of cash which has carried Biolase through up until now has been the proceeds of its $18 million equity offering competed two years ago.

Over the course of the past year, there have been numerous headlines detailing Biolase’s progress with various patent and partnership initiatives. This lasers for Ear, Nose and Throat (“ENT”), eye conditions such asGlaucoma, and the NewTom oral imaging product.

It may be the case that over coming years, one or more of these products might start to become a meaningful contributor to recurring revenue. However investors have largely learned to tune out these announcements until they produce real results.

As shown in its recent presentation, Biolase already has 352 patents on various new products issued and pending. Over 70% of these are related to WaterLase technology. Yet despite the progress on hundreds of patents over the past few years, there has been very little translation into recurring revenues. This is why investors have largely tuned out the similar announcements during 2013.

(click to enlarge)

Biolase has already put out guidance that it hopes to achieve approximately $68 million in revenues for 2013. This is the low end of what had previously been announced. This would be an improvement over 2012, but would still only put Biolase back on track with the revenues it had achieved in 2006. Biolase has not given guidance for when we would expect to see quarterly profits instead of quarterly losses.

When explaining the difficult Q2 results, Biolase offered a laundry list ofexcuses, including:

– disappointments in Germany

– delivery delays from Europe

– flooding in Canada

– non approval from Health Canada of Epic 10

– generic problems with Obama care

– rising interest rates

Basically, anything that could possibly go badly did go badly. But this has been consistent for years now. This was not an unusual quarter for Biolase.

In reality, management used incredibly poor judgment in waiting to issue equity. In Q1 the cash balance was already down to $1 million, such that the need for an offering should have been very clear. The share price had traded as high as $6.00, meaning that over $20 million could have been raised at a very attractive price. This would have given Biolase complete freedom to run its business for the next year or two without any cash constraints.

Instead, management waited until the cash was desperately needed. This has created a self fulfilling prophecy of a plunging share price and created significant uncertainty as to whether or not Biolase can raise enough money to satisfy the bank and keep funding operating expenses.

Near term investment thesis

In the near term, solvency concerns and the need to issue stock will entirely control Biolase’s share price. Biolase will be forced to issue up to $20 million of stock. If the stock price can hold up for a few more days then Biolase may be able to issue stock at around $1.40-1.50. But if the stock continues to fall then the offering price could start to approach $1.00. This is an urgent financing for Biolase and therefore the offering should be expected as soon as the S3 becomes effective. This could easily occur within the next few days.

Company background and investment considerations

The corporate predecessor of Biolase was Societe Endo Technic, SA an endodontic and laser product company founded in 1984 in Marseilles, France. In 1994 the company changed its name to Biolase and in 1998 the company adopted the focus it maintains today, developing, manufacturing, and marketing lasers for applications primarily in dentistry as well as dental imaging equipment.

The most important segment of the company’s business is its lasers. Biolase has two categories of lasers, Waterlase, its flagship product, and Diode. Using patented technology, Waterlase combines water and laser energy to perform procedures that would otherwise require dental drills, scalpels, and other traditional cutting instruments. Diode is used to perform less invasive procedures such as pain therapy and teeth whitening. Biolase has 160 issued and 150 pending patents for its laser technologies.

As the company’s flagship product, Waterlase is the most important part of Biolase’s strategy. The key selling points of Waterlase are that compared to traditional methods it reduces pain while improving the safety of dental procedures. Biolase also claims that Waterlase has an advantage because it may be used on both hard (anything involving teeth and/or bone) and soft tissue, something that is not available in other technologies.

Biolase cites the 2007 American Dental Association Survey of Dental Services Rendered ( the “ADA Study”) indicating that more than 200 million hard tissue dental procedures are performed annually in the United States alone. The existing technologies that are currently being used for the vast majority of these procedures are high speed drills for hard tissue (preparing cavities for filling, root canals) and cutting instruments for soft tissue (reshaping gum lines and related procedures).

High speed drills can be problematic because their forces may damage the patient’s dental structure, potentially even causing the patient to need another procedure. Also, drills obviously require anesthesia, and because it is not recommended to anesthetize more than half of the mouth at once, a patient may have to return for multiple procedures if drilling is required in many different parts of the mouth. Finally, the tools used in these procedures can potentially pose risk of infection to patients. According to Biolase, 15 % of dental burs carry “pathogenic microorganisms” which may infect a patient. Cutting tools used on soft tissue don’t appear to be nearly as problematic, but Biolase claims that the discomfort and bleeding are problematic compared to the reduced difficulties that result from use of its lasers. As stated above, Waterlase precisely cut hard and soft tissue with “little or no” damage to surrounding tissue.

While reduced discomfort and tissue damage is obviously a key benefit for patients, the benefits for dentists are at least as important as they are the decision makers.

The company believes that dentists benefit from using its products because of the additional procedures that may be performed using Waterlase that would not be available to dentists with traditional tools. This gives the dentist an opportunity to increase his or her revenue. Biolase also believes that the reduced discomfort provided by its lasers may increase the patient base for dentists who use them, and that the reduced number of post-operative complications that result from reduced surrounding tissue damage will be an important benefit as well.

The company admits that currently only a small percentage of dentists use lasers, and that they are more expensive than traditional tools. Biolase is clearly hoping that its products are in fact superior to the degree it believes, and that as a result its lackluster sales growth thus far will be replaced by more impressive performance. With all this in mind, Biolase is optimistic on the market demand for flagship Waterlase as well as Diode and its other products. However, its important to note that these products have already received FDA approval and have therefore already been exposed significantly to the market, meaning that much of the growth is already factored in with current market acceptance.

Of secondary importance in the company’s product line is dental imaging equipment. Biolase also has three main products in this category, the DaVinci Imaging, Cefla NewTom, and Trios intra-oral CAD/CAM. These systems provide an advantage over traditional technology because they are capable of providing three dimensional images as well as color and higher quality. They also have no time delay. Similarly to the lasers, these provide an advantage to dentists because they may increase the range of possible procedures as images that provide more information due to their more detailed and three dimensional nature may detect problems that would otherwise go undetected for longer periods of time.

Disclosure: I am short BIOL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Implications of Organovo Lawsuit

I last wrote about Organovo Holdings (ONVO) on July 24th.  Since my last article, there have been several new developments which further reinforce the short thesis on the stock. The stock has continued to fall as expected.

First, the S3 registration statement for up to $100 million of new shares and/or warrants has now become effective. Some individuals had previously taken comfort that no offering would be impending because the S3 was not yet effective. It is now the case that Organovo is free to issue up to $100 million of equity securities at any time.

Second, I have uncovered an undisclosed legal action against Organovo by their own investment banker, Spencer Trask Ventures (“STV”). The initial arbitration filing  was submitted on June 27th, when STV demanded compensation which is now valued at around $28 million. Under the terms of the original Placement Agency Agreement, Organovo had agreed to binding arbitration. However, on June 28th, Organovo  filed in New York Civil Supreme Court to attempt to fight the arbitration.

There have now been a flurry of arguments and counterarguments in New York Civil Supreme Court during the monthsof June and July.

One issue is that this may prove to be a significant financialissue for Organovo. But as a totally separate issue, this isalready a significant disclosure problem for Organovo.

None of this has been disclosed to investors, including in theS3 registration statement which just became effective a fewdays ago.

Preliminary points

Before getting into these issues, there are a few preliminarypoints that deserve to be made.

Following my article, Seeking Alpha contributor Jason Napodanowrote a forceful rebuttal to my article. It was his 4th bullisharticle on Organovo in less than 1 year.

In his article, Mr. Napodano makes it clear that the points inmy article are either entirely irrelevant or else downrightinaccurate. The author supports these statements with a mix offacts, opinions and anonymous postings from a Yahoomessage board.

There are now three main issues which investors need toresolve for themselves.

  1. How much (if any) of the 32 million share overhang iscurrently depressing the share price ?
  2. How much (if any) equity is Organovo likely to issue underthe recent S3 registration statement ?
  3. How much (if any) revenue is Organovo likely to generatein the next 1, 5 and 10 years ?

Clearly I disagree with Mr. Napodano on each of these points.

A substantial overhang pressing on the share price from the 32million shares from 2012 is evidenced by the fact thatOrganovo still filed a subsequent prospectus on these shares.Once the overhang is fully removed, there will not be additionalprospectuses.

Organovo is likely to complete a very large financing under the$100 million S3 sooner rather than later. It has been less thanone year since the company deliberately reduced the exerciseprice of the existing $1.00 warrants to just 80 cents in order toget money in the door at that price. We can also see from theSTV lawsuit that Organovo tried to incentivize STV to exerciseby reducing the strike price to just 60 cents. This means thatOrganovo was attempting to issue new shares at a price of just60 cents as recently as February / March.

For revenue, Organovo may have some prospects with liver cellmodules at sometime in 2014. But we have been given noindication of the certainty or the amounts which may beinvolved. The key point here is that the hype surroundingOrganovo is in connection with the 3D printing of humanorgans. Not even the most bullish authors expect to seemanufactured human organ revenues any time in theforeseeable future. Instead, we will continue to see smallamounts of revenue from grants and research collaborations.Historically these have typically been in the range of six figureamounts.

In the meantime, we can see that Organovo has beensuccessful in two areas:

– selling stock to investors at $1.00 (or below)

– elevating its share price to above $6.00

The company has recently been sporting a fully diluted marketcap of nearly half a billion dollars, despite the followingfinancial metrics:

– lifetime revenues of just a few million dollars (coming fromgrants and research)

– non cash assets (including all intellectual property) of lessthan $2 million

Metrics like these do not justify a market cap anywhere nearhalf a billion dollars.

A very small but vocal minority of readers continues to posttheir emotional comments below these articles. However amuch larger (and silent) majority chooses to express theirviews by selling their stock rather than typing up rabidcomments.

Prior to my article, the stock was hitting $7.70 in pre markettrading. Following my article the stock fell to $6.50.

It is now the case that all investors have the benefit of fullinformation from these various articles and comments and theshare price continues to slide rather than recover any lostground. Following his article on Organovo, Mr. Napodano left asubsequent comment stating that he believes that “fair value”for the stock is around $4.00-5.00 – an additional decline of asmuch as 20% from the current level. In the near term, I wouldagree with this statement, which is why I continue to be shortthe stock. Although any potential equity offering couldpotentially push the share price even lower.

An undisclosed legal action

In its past financings, Organovo used the services of SpencerTrask Ventures for raising what now totals roughly $28 millionin proceeds from stock and warrants. As of March, Organovohad $15 million in cash remaining.

The lead individual involved was Adam K Stern, a ManagingDirector with STV. Mr. Stern also became a Director ofOrganovo.

According to the terms of the Private Placement Agreement,Organovo would pay to STV a cash fee equal to 10% of theproceeds along with “agent warrants” ($1.00 strike price, 5 yearmaturity) equal to 20% of the stock issuable to investors.There was also an 18 month “tail” provision allowing foradditional fees to be payable to STV based on subsequentcapital raises. A key point of contention in the current lawsuit isthat it was agreed that STV would be appointed as an exclusiveWarrant Solicitation Agent at least 20 days prior to any noticeof redemption. Organovo agreed to not contact any of theinvestors introduced on STV’s proprietary investor list.

In 2012, Organovo Director Stern left Spencer Trask and wentto Aegis Capital. Shortly thereafter, the arbitration suit statesthat Organovo began the warrant solicitation to raise newmoney from STV customers. But instead of using (or evennotifying) STV, Organovo used Mr. Stern’s new firm, Aegis.

In total, Organovo raised $14.8 million through the warrantexercises. In fact, Organovo lowered the exercise price onwarrants to just 80 cents in order to raise new money at thatlevel.

STV did not find out about any of this until it became publicinformation through Organovo filings.

STV and Organovo are now in a protracted legal battle in whichSTV is demanding the disgorgement (and payment) of $14.8million along with $1.3 million in cash fees and the issuance of2.9 million warrants owed. The warrants alone would currentlybe worth around $12 million. Total consideration is thereforenow in the area of $28 million.

During 2013, and after the warrant transactions conducted viaAegis, Organovo and STV began negotiating a Warrant Agreement which would arrange for payment of compensationto STV. A second draft of the Warrant Agreement was alsoprovided.

On March 1st, Spencer Trask’s attorneys sent an email toOrganovo CEO Keith Murphy rescinding the proposedagreement. A copy of the rescind email can be found here.

Following the rescinding, Organovo still sent small payments toSTV, however these payments totaled just $115,000, instead ofthe much larger sum demanded by STV.

Section 13 of the Placement Agency Agreement states (in ALLCAPS) that any “dispute, claim or controversy” which arises withrespect to this agreement will be submitted to JudicialArbitration and Mediation Services Inc. (“JAMS”) in the State ofNew York.

STV filed for arbitration on June 27th.

The next day, on June 28th, Organovo filed to fight the movefor arbitration, stating that the Warrant Solicitation Agreementvoided both the compensation earned by STV as well as theneed for arbitration.

As is often the case, many dirty secrets get spilled out inlawsuits. Organovo reveals that it had already agreed to pay toSTV $23 million in exchange for helping Organovo raise just$15 million in proceeds. The need to pay such a fee isstaggering in and of itself.

The lawsuits also reveal that Organovo was willing to lower thestrike price on STV’s warrants to just 60 cents, in order to raiseequity at that level. This was not in the distant past. This was inFebruary / March.

Both of these facts speak loudly to the fact that Organovo hasalways been eager to issue equity at just about any price, nomatter how low. The company has virtually no non-cash assetsand continues to generate only minimal and non-commercialrevenues. So getting money at any price may well be the beststrategy.

But it also reconfirms my suspicion that if the company is eagerto issue substantial equity for just pennies, then it will likely bea very large issuer of equity with the price sitting at just over$5.00. A normal discount for an equity offering like this wouldbe around 20%, meaning that an offering would likely takeplace at around $4.00. The stock price would then reactaccordingly.

Investors now need to ask themselves two very importantquestions:

First, how much of the $28 million in demanded compensationwill Organovo end up paying to Spencer Trask ?

Second, why are investors hearing about a potential $28million legal liability from me, rather than from Organovo in an8K or S3 legal disclosure ?

Reverse mergers in perspective

Commercializing a new product or service in the real world is anarduous and time consuming task. Successes are rare andoften take decades to make themselves evident.

Reverse merger stock promotions, in sharp contrast, are fareasier. It is very simple to achieve 8 and 9 figure fortunes inthe space of just a year or two.

Step one is to acquire the busted shell of a defunct company.Step two is to complete a reverse merger and inject sometoken amount of assets. Step three is to change the name.Step four is to heavily promote the story.

A few years ago, when China was hot, it was possible to create$500 million dollars by simply creating a reverse merger withthe “China” in the name. Hundreds of these companies wereuplisted to the NYSE and NASDAQ. Before that, when solar washot, there were numerous half billion dollar companies createdjust by having some hint of a solar business. Prior to thatadding “.com” to a companies name would often create similarvaluations for reverse mergers. But in the end, when thesecompanies failed to produce profits, we saw them ultimatelyplunge to the pennies.

As noted in “Get Rich or Die Tryin'”, there are two kinds ofinvestors in these promotions. The “Get Rich” crowd gets inearly at very low prices.

It is important to note that the Get Rich crowd has no intentionof waiting for the product to be an ultimate commercial success.Instead, they cash out when the promotion of the stock andthe story hits a peak.

Many authors (such as Mr. Napodano) have clearly expressedtheir views that the early investors in Organovo have alreadysold their stock – well before any commercial success is evenclose. They had no intention of waiting around for real worldsuccess because they were simply playing a stock promotion -not a product.

I agree that these investors will sell well beforecommercialization. But I also believe that they would be smartenough to wait for the price and liquidity which is provided bythe uplisting. This is why I believe that they are selling now.

Early investors cannot sell unless someone else is doing thebuying. Likewise, investors who buy these stocks should beaware that every time they buy, it is the result of someone elsebeing eager to sell. This is where the Die Tryin’ crowd comes in.

It is well known that institutions tend to steer clear of reversemerger promotions. As a result, reverse mergers rely heavilyon promotion to retail investors.

For example, Organovo has made ample use of a servicecalled

Retail investors can often take comfort from various sources of”validation” which may not be appropriate.

For example, some investors believe that an uplisting to theNASDAQ or the NYSE is reflective of some sort of judgment onthe investment merits of a stock. This is quite clearly not thecase.

In recent years, there were hundreds of Chinese reversemergers which uplisted to the NYSE and the NASDAQ. It wasultimately uncovered that many of these companies wereempty shell frauds with virtually no assets or employees. Mostof these companies were delisted to the pink sheets just asquickly.

The only point I am trying to make is that an uplisting willimprove liquidity, but does not have any implication for theinvestment merits of a company. Note: I am not making anysuggestion that Organovo is a fraud.

Likewise, many investors assume that obtaining a researchgrant is also validation of the long term potential of acompany. Sometimes this can be the case. But we can also seethat the list of non-productive research grants is very long andvery large.

Examples include a $3 million federal grant to study the gameWorld of Warcraft and a $2.6 million program to teach Chineseprostitutes to drink responsibly.

My point is not to suggest that Organovo’s grants are withoutmerit. Instead, my point is to suggest that obtaining a fewmillion in grant money is a very common occurrence for manycreative ventures in the US.

So far, Organovo has not achieved any meaningful degree ofcommercial success. But the stock promotion has beenextremely successful.

Despite minimal assets and revenues, the company has beenable to briefly exceed half a billion dollars in market cap. Therecent rise briefly put the value of CEO Keith Murphy’s stock atnearly $40 million in a very short time since coming public.

Fortunes like this often take decades to achieve when one isdependent upon the actual commercial success of a product.But with reverse merger stocks, they often take just a year ortwo.

Ultimately, Organovo may end up being the reverse mergerthat transforms the nature of medicine as we know it. If so, itwill end up being worth many billions of dollars.

On the other hand, if Organovo fails, someone will come along,acquire the defunct shell and start over with a new billion dollarreverse merger idea. The name will be changed and so on.

Fortunately we are all able to come to our own investmentconclusions with respect to these divergent potential outcomesand we are all able to act accordingly.

I am short Organovo.

ONVO: Red hot but set to drop

Organovo (ONVO) is about as hot as any concept stock could ever be right now. It sits right at the crossroads of 3D printing and regenerative biotechnology. In addition, Organovo just uplisted from the OTCBB to the NYSE, further fueling the strong enthusiasm.

Following the uplist, Organovo soared from $3.90 to $8.50, a gain of over 100%. But since then it has been dropping almost daily. By Monday it had fallen 26% to $6.29. However, yesterday the latest issue of Popular Science hit the news stands with a cover story featuring futuristic “bio-printing”. Organovo was mentioned and the stock soared as much as 15% due to the article alone.

The article was clearly good for a predictable trade. It was also welcome relief for investors who were getting tired of seeing their stock give up gains each day. But those who are still left holding are likely walking in front of a moving train.

Popular Science has been a long time source of very interesting and thought provoking topics including flying cars and life on Mars. But in stoking the imagination, it tends to ignore many of the practicalities that these futuristic ideas entail.

With Organovo, we are now seeing a “rush for the exits” from different classes of sellers who are trying to beat each other to hit the sell button. With over $300 million in stock coming for sale, this will easily take the stock back to $4-$5 very quickly.

Overall, those who choose to hold shares of Organovo are likely fighting a losing battle which really just comes down to a huge supply of available shares coming for sale which can overwhelm current demand.

No one has a perfect crystal ball to predict where Organovo will be in 10 years time. The stock could be at $30 or it could be at zero.

While the concept is extremely cool, the company is extremely speculative.

Almost all revenues (only a few hundred thousand dollars per quarter) at present are the result of government grants and research collaborations. Revenues from actual product sales are still years away at best. The stock currently boasts a market cap of over $400 million (over $500 million fully diluted), despite having almost no revenues or near term revenue prospects. Against this $500 million valuation, the company has just $15 million in cash. Aside from this, the company has only $1.5 million in total assets. This is truly a “blue sky”, concept stock.

Fortunately, we all have the tools to predict the share price performance in the near term.

A sharp rise upon the uplisting was certainly easy to predict. The company had implemented all of the perfunctory corporate governance and structural measures necessary for an uplisting. Management had also been hinting at it for some time. Anyone who sold before the uplisting was either not paying attention or was just too impatient to wait for this predictable move up. However, the 100% gain was certainly larger than anyone could have predicted.

Now that the uplisting is behind us, a near term drop of at least 20-30% is easy to predict due to the following four very visible sell catalysts:

First, Organovo overshot on its uplisting, doubling from $3.90 to nearly $8.00 on that event alone. Many stocks will see a bump up of around 10-30% upon uplisting due to the improved liquidity that a senior exchange provides. But given that an uplisting involves no fundamental change in the business, any increases of more than 30% are typically very short lived. The 100% gain experienced by Organovo was highly unusual and has already begun to reverse itself.

Second, there is a substantial overhang of 32 million shares (around $200 million) from the sellers who were named in the April prospectus from the Reg D offerings. These investors would certainly not have sold before the uplisting. For anyone who had already been waiting for over a year to sell their stock, waiting an extra few months for the uplisting would be just plain common sense. The stock began its run up after the announcement on July 9th, but has only been on the NYSE for a few days. As a result, there simply has not been enough time for these sellers to complete their selling.

An article in May entitled “Get Rich or Die Tryin’” highlighted this overhang and caused a brief dip in the share price. But the volume that resulted from that article was nowhere near what would have been necessary to clear this number of shares and the price drop was not nearly as steep. So again, it is only sensible to conclude that the majority of holders were waiting for the uplist catalyst in order to sell their shares. The liquidity event that they have been waiting for is happening right now.

It should also be noted that many of the 16 million warrants that are listed in the prospectus would have already been exercised, either voluntarily or due to forced conversion by the company. When the warrants are exercised, the holder is then left with shares which must be sold. So the simple act of exercising the warrant does not remove the overhang. Only selling the underlying shares removes the overhang.

Third, Organovo just filed an S3 registration statement for the sale of $100 million in new shares. The S3 was just filed on July 17th, meaning that it was ready and waiting for the uplisting. By filing immediately after the uplisting, Organovo has signaled its intent to proceed with the offering as quickly as possible, taking full advantage of the strong share price. But with an offering size of around 25% of market cap, this deal will require a discount of around 20%. Relative to the current price, that would price the offering at around $5.50 plus warrants. However, the offering is now competing with the existing Reg D sellers. Any additional selling from the Reg D sellers will mean that Organovo must price its $100 million offering at an even lower level.

Forth, the uplisting has also made Organovo a much easier stock to short. Shorting a stock which just spiked due to its uplisting is often an easy money trade. But when such a stock has as much as $300 million in imminent selling due to two registration statements, it becomes almost too easy for short sellers to pass up. There is ample ammunition to make the stock fall, but there is virtually nothing that could make the stock rise substantially for more than a day or so.

As with the Reg D sellers, short sellers will likely drive the share price lower. This will potentially cause Organovo to price its equity offering below $5.00 if the price dips even slightly.

We can already see that the shorts have been flocking to Organovo as soon as the uplist was complete. The stock was quickly placed on the short sale restriction list due to heavy shorting. Borrowable shares have been snapped up almost as quickly as they become available due to very high demand.

Trading the uplisting

Anyone who follows uplistings should certainly have predicted that this one was coming. An uplisting is actually not a difficult process to undertake. In fact it is entirely mechanical and perfunctory.

Obtaining the original shell on the OTCBB is as easy as completing a reverse merger with a once-defunct company. Organovo completed its reverse merger in a series of transactions in 2011 and 2012.

From there, getting to the NYSE was easy. All that Organovo had to do was implement a board which was comprised mainly of independent directors and then establish three board committees (audit, nominations, compensation). The biggest impediment keeping most issuers from the NYSE or NASDAQ is the market cap and share price restriction. However, the sharp rise in Organovo’s stock this year made the uplisting almost a sure thing.

Organovo’s uplisting was entirely predictable and had been hinted at by the CEO for months. Despite this, the stock quickly doubled.

Investors need to keep in mind that there has been no fundamental change to the actual company which would change its valuation. It is the same company which now simply trades on a more liquid exchange.

In addition, many investors continue to be mistaken in assuming that the uplist implies some type of positive opinion being expressed by the exchange with respect to the company. This is absolutely not the case. Instead, the company simply fulfilled a simple check list of criteria and was then automatically accepted. In the past we have seen hundreds of companies undergo the identical process. A few years ago, it was the case that hundreds of fraudulent Chinese companies became listed on the NYSE and the NASDAQ. When they were ultimately delisted again due to fraud, the NASDAQ and the NYSE were very quick to point out that uplisting does not involve any qualitative assessment on a company’s investment merits.

The key point is that holding Organovo prior to the uplisting was an obvious and easy trade. The uplisting was almost certain to provide a quick boost of 10-30%. But once the share price spiked by 100% with no fundamental developments, selling it is now an even more obvious trade.

The impact of a 32 million share overhang

Back in April, Organovo filed a prospectus which allowed for the sale of 32 million shares of stock by selling stockholders. These shareholders got in at a price of just $1-2 per share around 18 months ago and are now sitting on 3-4 baggers in that time.

Expecting these shareholders to continue to hold such a quick homerun forever is just plain unrealistic. In addition, the timing of the uplist coming just 9 weeks after the prospectus suggests that this was very much a planned liquidity event for these shareholders.

Some may be tempted to think that these shares were already sold following the “Get Rich or Die Tryin'” article in May. This is clearly not the case. That article caused a brief dip in the share price. But the volume only exceeded 1 million shares for two days. Within days of the article, the volume was back down to 200,000-300,000 shares per day – not nearly enough to clear such a huge overhang.

The ability for these holders to eventually sell was entirely made possible by the uplist to the NYSE. Just prior to the uplisting, the stock was trading only around 100,000 shares per day. A full liquidation of 32 million shares would easily have taken months and would have put extreme pressure on the share price.

Now the stock has far greater liquidity and the share price is 100% higher than where it was before the uplist.

Although this is highly beneficial for those who are selling, it will still mean heavy pressure on the share price for those who continue to hold. At current prices, the 32 million shares equates to around $200 million, or roughly 50% of Organovo’s market cap !

Even at prices of around $4.00, this means that many of these holders will still be sitting on 4 baggers. If selling at around $6.00 these holders are locking in quick 6 baggers. The point is that these sellers will likely not be very sensitive to price when locking in their tremendous gains. They have more to lose by waiting than they have to gain.

There has simply not been enough volume to allow for sales of 100% of these shares since the uplisting, which means that we will likely see continued pressure on the share price. We have already seen it dip from a high of $8.50 on Thursday to a low of $6.29 on Tuesday – a very quick retreat of 26%.

Evaluating the $100 million S3 offering

Organovo filed its $100 million S3 shelf registration statement just 1 week after it became listed on the NYSE. The timing of this filing was clearly not a coincidence.

Documents such as this will take the company and its legal counsel weeks to complete. But completing it before the uplisting would have been a waste of time and money because there would be many stock specific sections that would need to be redrafted following the move to a new exchange.

Instead the company clearly had a fully drafted S3 which applied to an uplisted stock even before the uplisting had occurred. They simply waited for the uplisting to take place and then filed the document almost immediately.

Given the price and liquidity before the uplist, launching such an offering at that time would not have been possible.

Offerings such as this can be differentiated between operational offerings and opportunistic offerings. Operational offerings are sized according to specific operational needs which are defined in the “use of proceeds” section. Opportunistic offerings are typically done simply to take advantage of an unusually high share price.

The offering by Organovo is really a combination of the two offering types. It is clear that the company does have an operational need. Losses have ranged anywhere from $10 million to almost $40 million – per quarter ! Yet the company currently has only $9 million in net cash. The company clearly needs to raise at least $30-40 million in the near term.

But the offering size of $100 million clearly reflects a view by the company that the current share price makes NOW the time to raise as much as possible.

This is further confirmed by the defined use of proceeds, which is totally open ended and non-committal:

Except as described in any prospectus supplement and any free writing prospectus in connection with a specific offering, we currently intend to use the net proceeds from the sale of the securities offered under this prospectus for general corporate purposes, including research and development, the development and commercialization of our products, general administrative expenses, license or technology acquisitions, and working capital and capital expenditures.

We may also use the net proceeds to repay any debts and/or invest in or acquire complementary businesses, products or technologies, although we have no current commitments or agreements with respect to any such investments or acquisitions as of the date of this prospectus.

We have not determined the amount of net proceeds to be used specifically for the foregoing purposes.

As a result, our management will have broad discretion in the allocation of the net proceeds and investors will be relying on the judgment of our management regarding the application of the proceeds of any sale of the securities.

Pending use of the net proceeds, we intend to invest the proceeds in short-term, investment-grade, interest-bearing instruments.

This is a very boiler plate use of proceeds definition for companies who wish to complete an opportunistic offering. It basically says “We know that we will need the money sooner or later, so just trust us.” It is also a very clear way of management saying that “at the current share price, we wish to sell every share possible”.

The problem for current investors is that the offering size is extremely large. At nearly 25% of market cap, the $100 million offering will likely require a 15-20% discount from the current share price. The offering is made more difficult given that the stock is almost entirely held by retail investors. A $100 million offering will clearly require the participation of institutions into a stock which has never had institutional interest. This will likely mean the further issuance of a large number of warrants as we have seen in the past.

All in all, if the offering were priced today, it would likely be priced at around $5.50 or below and would include warrant coverage. This would almost certainly send the share price back to around $4.50 in short order.

The problem is that now the company is competing with the Reg D sellers for who gets to sell first. If the stock falls below $6.00 due to Reg D selling, then the company may end up selling at below $4.50 under the S3 and having to include even more warrants.

For those who wish to remain longer term holders of Organovo, there is no reason to hold at a time when the share price is likely to exhibit a predictable decline of 20-30%. It is just as easy to sell now and buy back in at prices below $5.00 again.

Here come the shorts

One of the biggest positives of an uplisting is the fact that liquidity is greatly improved on a senior exchange. This will typically provide a boost to the share price. But it is often overlooked that the uplisting is typically the beginning of meaningful short interest. Once the share price rises, the new wave of shorts can often push it back down significantly.

Shorting OTCBB stocks is often a losing game due to the poor liquidity. As a result, funds who wish to short an OTCBB stock will simply keep it on their watch list and wait until it uplists. This strategy has an added benefit in that it usually becomes possible to short the stock at a noticeably higher level due to the predictable pop upon uplisting. This is exactly what we have seen with Organovo.

This short selling should be expected to create additional downward pressure on the stock at just the time the company is looking to issue stock.

Now there are 3 major competitors all selling stock at the same time: Reg D sellers, short sellers and the company itself with its $100 million S3.

Prior to the uplist, only about 1% of shares were sold short. This is virtually nil. When short interest is already high, any changes in the short will not have a noticeable effect on the share price. But when short interest is going from nothing up to something high, the effect on share price can be pronounced. As a high flying stock with minimal revenues, Organovo could expect to see as much as 25% of shares sold short – around 15 million shares. At a minimum, this will serve to cap further upside in the share price. At a maximum, it could end up driving the share price much lower when combined with the Reg D selling.

Valuation considerations for Organovo

At the present time there is no defensible way to place a fundamental valuation on shares of Organovo. The best we can do is try to predict how certain events will move the stock in one direction or another. The uplisting saw a move up while the flood of shareholder and company selling will knock the stock back down substantially.

Organovo now sports a fully diluted market cap of around half a billion dollars. This market cap will grow considerably larger once the $100 million S3 offering is completed.

Against this, the company has only generated lifetime revenues of a few million dollars. These revenues have primarily been the result of government grants and research collaborations. There have been virtually no meaningful revenues from actual sales of a product. Any material revenues are still years away at best.

As a result, investing in Organovo is largely about investing in a story, not about investing in financials. This is the primary benefit of using a reverse merger to list on the OTCBB.

If Organovo were a private company attempting to tap private equity investors, there is simply no way that these investors would award a half billion dollar valuation to a company which only generates a few hundred thousand dollars per quarter in total revenue.

But the reverse merger-OTCBB-uplist process is both cheap and easy. This allows the company to tap into retail investors who are willing to invest based on a sexy story and based on current market hype for both biotech and 3D printing.

Investors cannot say that they were not warned about the speculative nature of Organovo’s stock. The list of risk factors runs longer than most companies at 13 pages. The company has made it clear that they are working with an unproven emerging technology which may never amount to anything. The have also clearly stated that they will continue raising money and incurring losses for the foreseeable future. This is all part of the norm for this category of speculative “concept stock”. There is simply no foundation upon which to build a traditional valuation framework.

For those who choose to invest in Organovo, it is essentials to keep abreast of any new corporate developments. But of even greater importance is the continuous monitoring of the market for signs of increased or decreased hype surrounding the space. With no real revenues or assets, this stock is affected far more dramatically by sentiment towards the space than it is by actual developments at the company.

Organovo – longer term investment thesis

Organovo is hoping to one day commercialize technology that generates human tissues. The company hopes that its technology could one day generate tissues for use in drug discovery and development, biological research, and therapeutic implants. The previous technologies in the field have relied on monolayer (2D) cell cultures. Organovo hopes to create constructs in 3D that could potentially replicate human biology.

According to the 10-K, Organovo’s technology is derived from the research of Dr. Gabor Forgacs, a professor at the University of Missouri. The company currently holds licenses to patents from the University of Missouri-Columbia, Clemson University, and Becton Dickinson. The Company has outright ownership of six other patents.

Organovo’s path to its current point in the development process has been long but the company still has far to go.

In 2004 Dr. Forgacs began working on organ printing at the University of Missouri-Columbia when his team was awarded the $5 million National Science Foundation Frontiers in Integrative Biological Research (FIBR) grant. This same team subsequently filed the first patent application for the NovoGen™ bioprinting platform. Following the technological developments under Dr. Forgacs direction, a founding team formed and Organovo incorporated in 2007. In July 2008 the company raised $3 million in angel funding, and Organovo opened laboratories in San Diego in January 2009. As Organovo continues down the path towards commercialization, the company has entered into collaborative research agreements with pharmaceutical corporations and federal grants as well. The company first began to form corporate partnerships in the drug discovery area with pharmaceutical and biotech companies in March 2011. In February 2012 the company went public in a $15.2 financing round. Clearly, the company has grown enormously since its $3 million angel investment in 2008 and $15.2 million financing round in 2012, one and a half years ago. However, Organovo’s technology remains extraordinarily speculative and conceptual. It is likely 10 years away from being any sort of reality.

The key to the company’s technology is the NovoGen MMX Bioprinter™ which the company proudly states it developed within two and a half years of commencing operations. Organovo’s technologies enable various types of tissues to be created using combinations three types of building blocks that themselves include combinations of “bio-ink” comprised of only cells and “hydrogel” comprised of biocompatible gel. The company believes that at least part of the tissues its technology creates could be constructed solely of cells, a key differentiator from older technologies. This feature enables organovo to generate architecturally and compositionally defined functional human tissues for in vitro use in drug discovery and development. This can potentially allow more efficient drug development by eliminating the need for actual human subjects in some cases. To illustrate the enormous utility of this, imagine how much more efficient it would be to test drugs on human tissue that can be constructed in a lab than it would be to test drugs on actual people who must be recruited and for whom safety must be assured. Moreover, tissues created using Organovo’s technology may be more effective than animal testing. Organovo’s fully cellular constructs may also offer advantages in regenerative medicine such as augmenting or replacing damaged tissues. In addition to products for use in drug discovery/development and regenerative medicine, Organovo plans to sell 3D bioprinters for use in medical research and a portfolio of consumables for use with the bioprinters. The role of consumables is conceptually similar to the role of ink in the business model of traditional printer manufacturers.

While the products Organovo is developing may in the long term represent significant advances over today’s technology, the company is innovating in a rapidly changing field, and by the time the company’s products reach the market the landscape may be very different. While Organovo works on their 3D printing technology, pharmaceutical, biotech and diagnostic companies, as well as research institutions and government agencies are pursuing related technologies that have the potential to make Organovo’s technology obsolete. In fact, the scariest thing is that it is very possible that this obsolescence could occur before the company is even able to realize any material revenues from its technology.

Disclosure: I am short ONVO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

MDXG: All signs say sell

MiMedx Group (MDXG) is a very interesting company which could potentially have a promising future.  But at the current price there is now substantial downside risk with very little chance for further upside.

There have been a small number of factors which pushed its share price up by 60% in recent weeks, making its peak gains since 2012 in excess of 600%.

However, we are now seeing the convergence of several very strong and concrete sell catalysts which could presage a drop of at least 20-30% in the near term. The recent departure of the chairman and founder, along with his large sales of stock have already begun to cause the shares to start dropping daily.  The next leg down will likely be the result of a massive S3 offering where other insiders will be cashing out.  The total size for the S3 is a very large at nearly 25% of the company’s market cap.

MiMedx describes itself as a developer of “regenerative biomaterial products processed from human amniotic membrane”.  The company collects human placentas via a donor program from mothers delivering their babies via C sections.  These mothers can opt to donate the placenta rather than have it discarded as medical waste.  The placentas are then processed into products which can be used to aid healing in traumatic wounds and burns.

The use of placentas in medical care has been around since the early 1900’s. However it dropped significantly in the 1980-1990’s due to concerns over hepatitis and HIV transmission.

MiMedx now sports a fully diluted market cap of $660 million, however the company has never generated a profit.  Total annual revenues stand at just $27 million.  Revenues have been growing, but the net loss has been consistent for the past few years at around $8-12 million. As a result, the company has no retained earnings and instead has an “accumulated deficit” of $71 million.

At its current stage of development, the company must still spend very heavily on incremental sales and marketing spend to generate any additional revenue. As a result, there is not much chance that MiMedx will see profitability in the foreseeable future.


From its quarterly financials, we can see the following data:

–          Gross margin is high due to low cost of donated placentas

–          But typically around 90% of gross profit is consumed immediately by SG&A

–          As a result, losses continue to grow despite slightly increasing revenues

On the balance sheet side, the company runs a very “asset light” business model with only $3 million in Property, Plant and Equipment.  The current cash balance is only $5 million relative to a $2 million quarterly cash burn. Both of these factors mean that there is virtually no cushion of safety relative to its $660 million market cap.

The company now becomes difficult to value because there are no earnings and virtually no cash or even assets.

The stock has had a very good run this year, doubling from $3.84 to over $7.00 in June.  Part of the run has been due to the company’suplisting to the NASDAQ in April. Prior to April, the company had been a relatively illiquid micro cap on the OTCBB.  This event saw the share price immediately pop by nearly 40% from its then price of $5.00 to over $7.00. It is almost always the case that small OTC companies will experience a brief pop following their uplist to the mainstream NASDAQ.

The stock also benefited from being added to the Russell 2000, 3000 and Global Indexes on July 1st.  Index rebalancing means that index tracking funds simply must buy the stock once it is added to the index, regardless of whether or not it may be poised for a near term decline.  Once the stock was uplisted to the NASDAQ, getting it into the Russell was fairly straightforward and was almost guaranteed to provide a boost to the share price. The Russell indexes cover around 98% of all traded small cap stocks, so inclusion of MiMedx was almost a certainty.

Both of these recent catalysts delivered a boost to MiMedx shares, but in both cases they are short term boosts that were not the result of fundamental business changes.

There have recently emerged several very obvious “sell signals” at MiMedx.

The biggest question for shareholders to ask is “why should we keep holding as the company and the insiders are selling millions of shares at the top ?”.

First, MiMedx’s charismatic and well known Chairman (Steve Gorlin) juststepped down to pursue other interests as of June 26th.  His resignation came shortly after the company was successfully uplisted to the NASDAQ.  An 8K was filed, but there was no press release communicating the resignation to the street.

Mr. Gorlin had been Chairman since its inception in 2008.  He has also been the influential founder of a host of other successful biotech companies including Hycor Biomedical,  Theragenics Corp, CytRx Corp, Medicis, EntreMed, MRI Interventions, DARA BioSciences, and Medivation.

Mr. Gorlin is not just stepping down from MiMedx, he is also selling stock in large size.

In the past year, Mr. Gorlin has already sold over 1.1 million shares, including 50,000 shares which have been sold since the uplisting. His most recent sales were completed at $6.46, but his earlier sales from late 2012 were as low as $2.70.

When key leaders at a company decide to step down and sell their stock, it is always worth noticing.  These are presumably the individuals that know the most about a company and the prospects for its share price. Even when they are stepping down, they always have the option of holding on to their shares. But in this case Mr. Gorlin has been selling heavily.

But the biggest catalyst for a potentially sharp move downwards is the filing of a massive S3 registration statement by MiMedx which allows for the sale of $150 million in stock – nearly one quarter of the market cap of the entire company. This statement was just filed in July.

Two thirds of the shares to be offered will be new shares, delivering up to $100 million in proceeds to the company.  But one third of the shares (around $50 million worth) are coming from selling stock holders who are looking to exit their position in MiMedx.

Having $50 million in stock coming from selling shareholders sends a very strong sell signal to those who are still in the stock.  Meanwhile a deal size which is around 25% of the company’s market cap is likely to cause an automatic drop of at least 20-30% once the shelf becomes effective in the next few weeks. This would imply a price somewhere below $5.00.

MiMedx is not a widely followed stock, with only two boutique analysts covering the company.  Neither one is from a major Wall St. research house.  However, these downward catalysts have not escaped the attention of some of the more astute shareholders. The share price has already begun to decline in the wake of Mr. Gorlin’s resignation and the filing of the S3.

The investors who are doing the selling are no doubt asking themselves why they should wait around as the company and insiders sell millions of shares into the market.  The near term direction of the stock is now quite predictable.

Prior to Mr. Gorlin’s resignation 3 weeks ago, the stock had hit a new high of $7.72.  Following the resignation, the stock quickly came off by around 10-15% before stabilizing.  The shares had recovered to $7.00 by July 2nd.  When the S3 was filed on July 3rd, the stock once again quickly dropped to $6.50.

The shares have continued to grind lower since that time and are now testing the $6.00 mark.

Predicting the actual offering price for the massive secondary is difficult for several reasons. First, the stock is up 600% since 2012.  New investors will clearly require a substantial discount to ensure they are not buying at the top of a spike.  Second, the size of the offering is so large that it will be difficult to manage in terms of daily trading volume and percentage of float.  And third, given that the company still has minimal revenues, no profits and minimal assets or cash, there is no “intrinsic floor” above which MiMedx should trade.

As a result, an offering price of $4.50-5.00 is most likely to be the case. This represents about a 20-30% drop from current levels. At prices below $4.00 MiMedx starts to present an attractive buy.  But at prices above $5.50, there is still clearly substantial downside.  At prices above $5.50, MiMedx is clearly either an “avoid” or a “short”.

Company fundamentals – longer term prospects

Over the short term, the insider selling and the huge S3 offering will clearly control the direction of the share price.  But once that overhang is removed, MiMedx will trade according to its fundamentals and performance. As a result, over the longer term, it is necessary to have a better understanding of the company’s products and their prospects.

MiMedx’s primary technologies are AmnioFix and EpiFix in tissue repair, which together constituted 95 % of revenues in 2012.

MiMedx went public via reverse merger in 2008, but it was only in 2011 that the company acquired its primary tissue repair business in the form of Surgical Biologics. At the time of the acquisition Surgical Biologics developed allografts (tissue transplants) processed from the membrane of the amniotic sac to be used for a wide range of medical applications including ocular surface repair, gum repair, wound care, nerve/tendon protection, spine surgery and burn treatment among others.

Following the 2011 acquisition, the new company launched what are now the company’s key products. First MiMedix launched AmnioFix to enhance soft tissue healing. The primary applications for AmnioFix are in surgical, sports medicine, and orthopedic medicine. Shortly thereafter the company launched EpiFix, a similar product but repurposed for enhancing wound care, especially the healing of chronic, hard to heal wounds such as burns and diabetic foot ulcers. MiMedx believes the wound care market is the largest opportunity.  Both Products are derived from dehydrated Amnion/Chorion membrane (dHACM) using MiMedx’s proprietary purion process which produces dHACM from donated amniotic sacs. To protect the critical IP of the Purion process, MiMedx has 5 issued patents, and over 20 pending. The key to the effectiveness of both products are the numerous growth factors, cytokines, and extracellular matrix proteins in dHACM. Not only do the company’s products reduce time, but also total cost to heal a soft tissue injury. Notably, MiMedx’s products also have a five year shelf life at room temperature.


A key distinction between MiMedx and other companies with novel healthcare offerings is that MiMedx’s products have not been approved or reviewed by the FDA as they qualify for section 361 of the Public Health Service Act. As stated by MiMedx’s 10-K, if a product qualifies for Section 361, “no FDA review for safety and effectiveness under a drug, device, or biological product marketing application is required.”


While the company has already implanted its products in many patients, it is impossible to know the exact impact of this regulatory difference over the long term. The most notable risk from this specialized classification is the possibility that the FDA could reclassify it. Obviously this would be enormously detrimental to MiMedx’s businesses, as the company could potentially be forced to apply through the typical lengthy and expensive FDA approval process. As stated in the 10-K, “We also cannot assure you that the FDA will not impose more stringent definitions with respect to products that qualify as 361 HCT/Ps.”

To qualify for section 361, a product must be minimally manipulated (from the original tissue), intended for homologous use, manufactured with nothing except water, crystalloids,  or sterilizing/preservative agents, and not dependent on living cells for its primary function. It appears that if the definition of homologous use were made more stringent, MiMedx could be at risk.
MiMedx has experienced strong revenue growth as the company’s products have been adopted in various situations requiring regenerative therapy. Of 2012’s $27.1 million in total revenue, 48 % was derived from surgical and sports medicine (AmnioFix), 42 % was derived from wound care (EpiFix), and 10 % was derived from other sources. However, the company expects EpiFix sales to overtake AmnioFix sales. Following the departure of founder Steve Gorlin, MiMedx is run by Chairman and CEO Pete Petite.  


MiMedx is an interesting company with an interesting product.  Regardless of whether investors are selling at $5.00 or $7.00 the stock can still be considered a homerun vs. its price of just $1.00 last year.

Revenues continue to grow, but the required SG&A spend has continued to prevent MiMedx from breaking a profit. The company has only $5 million in cash and only $3 million of Property, Plant and Equipment.

Given that the company now sports a $660 million market cap, it is easy to see why recently departed founder Steve Gorlin and other insiders have been quick to want to sell millions of shares at current prices.

The S3 statement sets MiMedx up to offer $150 million in stock, roughly one quarter of the company’s current market cap. As a result of the size and the large component which is insider sales, the upcoming offering will most likely be priced below $5.00.

The insider selling and the massive S3 overhang mean that the next 20-30% of downside in the stock is highly probable in the near term.

But at prices of $4.00-5.00, the stock could start to become an attractive buy depending on how the business continues to build.  It should be kept in mind that at prices of $4.00-5.00 (post offering) MiMedx will be very well funded with over $100 million in cash.  In addition, the overhang from selling insiders will have been removed.  Both of these strengthen the buy argument for MiMedx at prices of $4.00-5.00.