Bronte Capital

Santander Preferreds: Are North American Grandmothers brave, ignorant or insane?

2012-05-26T16:49:00.003+10:00

There is - at least amongst North American grandmothers who are the natural buyers of American listed bank preferred securities - a love of yield.

Santander (the Spanish mega-bank) has preferred securities issued in America - they mostly replaced the preferred securities of Sovereign Bank - a Santander-owned US regional bank.

But they are equity securities of Santander - taking full equity risk for a high (but limited) yield.

Linked (here) is the Google Finance page for one such security. Par value is $25 and the last trade is $25.65 - a small premium to par.

What could possibly go wrong?

OK: plenty could go wrong - but we don't need to analyse whether the Spanish mega-banks will succeed or fail - all we need to do is observe how bizarre the pricing is. Why would you own this preferred when you could own the common? The ADR is trading at $5.66 - and good earnings (2009 would you believe) were $2.24 per ADR. The common is two and a bit times normalized earnings. The no-failure earnings yield on the common is 40 percent (and if it does not blow up you will get capital appreciation). The prefs are at 10 percent yield.

There is a good chance that Santander never again earns "normalized earnings". There is a crisis going on...

But go tell that to the preferred holders who are happy to take a very similar risk to the common for a 10 percent yield and no chance of capital appreciation. They must envisage a world where Santander is saved by equity dilution that somehow leaves them intact. After all they are presuming (through their holdings) that the preferred is more attractive than the common.

And they believe that just as the Spanish Government injects 24 billion euro into Bankia.

Brave. Or is it ignorant?

Or do the holders expect the Spanish government to bail out banks at no cost to the preferred holders as per much of North America? That does not seem likely to me. Or even possible.

John

PS. I lost good money on Washington Mutual preferred stock. But I purchased them at 25 cents in the dollar. This one is going to trade there very soon in my estimation.

Disclosure: trading short on the preferred. Covered the common a few dollars up from here. But you guessed that.

Gulfport Energy and Wexford Capital (Part VI): The independent directors

2012-05-24T21:35:00.000+10:00

As the previous posts have shown Gulfport Energy and Wexford Capital are related parties on many levels. All the major projects of Gulfport are essentially joint operations with Wexford or will be after proposed transactions.

Wexford holds this privileged position despite having sold down most of its shares.

On major transactions though (such as the sale of the bulk of the proven oil reserves to a Wexford entity) you find statements that are reassuring. This was - for their latest major related party transaction - the form of words:

A special committee of the Board of Directors consisting solely of independent directors negotiated and approved this transaction on behalf of Gulfport.

With all these related party transactions an independent director of Gulfport would really have their work cut out. The Chairman of Gulfport is - as shown - in many respects a Wexford man. Most the operations are on a day-to-day basis run by Wexford controlled entities. Gulfport has issued hundreds of millions of dollars in shares and invested the vast bulk of this money in Wexford controlled entities. Being an "independent director" of Gulfport would have to rank as one of the most involved directorships in corporate America.

So who are the independent directors. Lets crib this from Gulfport's website except that I am going to do it in reverse order because the directors start more colourful that way:

Craig Groeschel: Director

Mr. Groeschel has served as a director of our company since August 2011. Since 1996, Mr. Groeschel has served as a founding pastor of LifeChurch.tv, one of the largest churches in the United States, reaching over 30,000 people each weekend. Since founding LifeChurch, Mr. Groeschel has served on its Board of Directors. Under Mr. Groeschel’s leadership, LifeChurch has grown to 15 locations in the United States. Mr. Groeschel received a Bachelors in Business Marketing from the Oklahoma City University and a Masters of Divinity from the Phillips Graduate Seminary. Mr. Groeschel is a frequent speaker at various domestic and international forums and an author of a number of books.

Craig Groeschel is a very high profile pastor - running a church reaching over 30 thousand people each weekend. He hangs around with Brian Houston from the Hillsong Church in my home town (Sydney Australia). Hillsong was founded by (now deceased) paedophile priest Frank Houston. Frank was sacked by his Brian who now runs the show. [OK - I am a self-described godless liberal from Sydney. I have learned to loathe Hillsong and all that it stands for. My intense dislike of Hillsong might colour my judgement...]

Whatever: Craig Groeschel's church is nowhere near as controversial as Hillsong but it is easier to find tithing demands than charitable works on the internet. Here is one:

There are suggestions on the web that Craig Groeschel is one of the most financially successful pastors in the world however the church has stated that Pastor Groeschel does not even have access to the church check book.

As a godless liberal I will leave the estimate of spiritual success to other people.

It is also easy enough to find Craig promoting financial advisers who seem to get 12 percent annually from mutual funds without telling you which funds they are picking.

Independence is an issue with Pastor Groeschel. In a 2007 prospectus (withdrawn) for Diamond Back Energy Services Pastor Groeschel agreed to be a director. Do I need to say that Gulfport was a Wexford entity?

This Pastor is an independent director of Gulfport who negotiated a sale of the majority of Gulfport's oil reserves to a Wexford controlled entity called Diamondback. He was once slated as a director of a Wexford controlled entity called Diamondback.

Still he is independent now...

The next director is Donald L. Dillingham. Here is his CV cribbed from the website.

Mr. Dillingham has served as a director of our company since November 2007. Since August 2001, Mr. Dillingham has served as the Senior Portfolio Manager for Avondale Investments, LLC and Merit Advisors, Inc., each of which is a registered investment advisor. Mr. Dillingham is currently the Senior Portfolio Manager for two mutual funds, a member of the investment committee of Merit Advisors, Inc. and the Vice-President/Treasurer of the Merit Advisors Investment Trust. From August 2002 to December 2004, Mr. Dillingham served as an adjunct professor of finance at the University of Oklahoma. Mr. Dillingham has also served as Senior Vice President, portfolio manager and state director for J.P. Morgan Investment Management, State Director responsible for managing the financial planning services and product sales for the State of Oklahoma for American Express, and Vice-President of Investment Banking for Bank of America. Mr. Dillingham began his career in the finance industry with Stifel, Nicolaus as a fixed income analyst, risked based market maker and sales manager from August 1984 to May 1994. Mr. Dillingham received a Bachelors of Business and Administration in Accounting from the University of Oklahoma and his Masters of Business and Administration in Finance from Oklahoma City University. Mr. Dillingham is a Chartered Financial Analyst, a Certified Public Accountant and a Certified Financial Planner. Mr. Dillingham is considered an independent director.

I have not checked the veracity of this CV however there are a few things missing. Donald Dillingham is also a director of The Beard Company. This now trades on the pink sheets under the ticker BRCO. The Beard Company had quite good looking assets and "proven" oil reserves but still managed to run out of cash. It never went bust though - it just went quiet. It no longer files with the SEC.

He has also been involved in a tax case with some controversy. The website (with his CV) for what he appears to be his main business is here.

The next director is Scott E. Streller. Here is his CV.

Mr. Streller has served as a director of the company since August 2006. Mr. Streller is the principal and founder of Streller Insurance and Financial Services with the Farmers Insurance Group of companies. Mr. Streller’s agency is consistently recognized as one the top agencies in the nation and is a member of the elite President’s Council. Mr. Streller is a frequent guest lecturer to Oklahoma City based universities and high schools on the topics of finance, risk management and budgeting. Mr. Streller is a member of numerous non-profit boards and recently served as the operations director for the 2006 Senior PGA Championship. Mr. Streller received a bachelor’s degree in business administration from the University of Central Oklahoma and a master’s degree in athletic administration from Oklahoma State University. Mr. Streller is considered an independent director.

A tied insurance agent does not strike me as the obvious choice for such a difficult independent directorship. Whatever my problem is not with him being an insurance agent. It is with the assertion that Mr Streller is an "independent director". Gulfport discloses otherwise in the 2007 proxy. To quote:

Effective September 29, 2006, we entered into an administrative services agreement with Diamondback Energy Services LLC, which we refer to as Diamondback. Under the agreement, our services for Diamondback include accounting, human resources, legal and technical support. The services provided to Diamondback and the fees for such services can be amended by mutual agreement of the parties. The administrative services agreement has a three-year term, and upon expiration of that term the agreement will continue on a month-to-month basis until cancelled by either party with at least 30 days prior written notice. The administrative services agreement is terminable (1) by Diamondback at any time with at least 30 days prior written notice to us and (2) by either party if the other party is in material breach and such breach has not been cured within 30 days of receipt of written notice of such breach. We were reimbursed approximately $823,000 for services provided under this agreement during the year ended December 31, 2006. Our Chairman of the Board, Mike Liddell, is also the Chairman of the Board of Diamondback. One of our directors, Scott Streller, is also a director nominee of Diamondback. In addition, Wexford Capital LLC indirectly controls Diamondback.

I thought the Good Pastor was compromised having once agreed to be a director of Diamondback. But this is kind of special. Scott Streller is an independent director for the purposes of selling the Permian assets (that is the bulk of the proved oil reserves) to a Wexford controlled entity called Diamondback.

But in 2006-2007 he was director of a Wexford backed entity called Diamondback. The Pastor only agreed to be a director of the Diamondback entity.

The last independent director is David L. Houston. Here is his CV:

Mr. Houston has served as a director of the company since July 1998. Since 1991, Mr. Houston has been the principal of Houston & Associates, a firm that offers life and disability insurance, compensation and benefits plans and estate planning. Mr. Houston has served as a director of Bronco Drilling Company since May 2005. Mr. Houston was President and Chief Executive Officer of Equity Bank for Savings, F.A., an Oklahoma-based savings bank. Mr. Houston currently serves on the board of directors and executive committee of Deaconess Hospital, Oklahoma City, Oklahoma, and is the former chair of the Oklahoma State Ethics Commission and the Oklahoma League of Savings Institutions. Mr. Houston received a Bachelor of Science degree in business from Oklahoma State University and a graduate degree in banking from Louisiana State University. Mr. Houston is considered an independent director.

Mr Houston is a director of Bronco Drilling. Mr Liddell, the Chairman of the board of Gulfport (and a Wexford man) is also the Chairman of the board of Bronco. Oh, and Wexford controls Bronco. Again the issue of independence matters.

So there they are. The four independent directors of a company laced with related party transactions - possibly the four independent directors with the hardest job (assessing all those transactions) of any oil and gas company I know.

Still - and I should repeat this - the company has set up a "special committee of the Board of Directors consisting solely of independent directors" to negotiate and approve the major transactions on behalf of Gulfport. And that is good practice.

John

Gulfport Energy and Wexford Capital Part V: Parsing Gulfport's cash flow statement

2012-05-23T11:53:00.000+10:00

From the last 10Q here are Gulfport Energy's revenue numbers for the past three months:

	Three Months Ended March 31,
		2012		2011
Revenues:
Oil and condensate sales		$	64,004,000	$	45,196,000
Gas sales			613,000		720,000
Natural gas liquids sales			806,000		659,000
Other income			38,000		63,000

			65,461,000		46,638,000

They had $65 million in revenue.

Net income was $26.7 million dollars.

Here is the cash flow statement for operating cash flows:


	Three Months Ended March 31,
	2012			2011
Cash flows from operating activities:
Net income	$	26,869,000		$	21,174,000
Adjustments to reconcile net income to net cash provided by operating activities:
Accretion of discount - Asset Retirement Obligation		176,000			159,000
Depletion, depreciation and amortization		21,395,000			12,158,000
Stock-based compensation expense		681,000			77,000
Loss from equity investments		268,000			316,000
Interest income - note receivable		—			(36,000	)
Unrealized loss on derivative instruments		266,000			—
Amortization of loan commitment fees		112,000			110,000
Changes in operating assets and liabilities:
Increase in accounts receivable		(1,718,000	)		(5,419,000	)
Increase in accounts receivable - related party		(463,000	)		(160,000	)
(Increase) decrease in prepaid expenses		(57,000	)		618,000
Increase (decrease) in accounts payable and accrued liabilities		22,431,000			(709,000	)
Settlement of asset retirement obligation		(531,000	)		—

Net cash provided by operating activities		69,429,000			28,288,000

The cash generated was - believe it or not - slightly larger than the revenue - and over 40 million higher than profits. Part of that was depletion (depreciation adds to cash flow). Most the rest was simply an increase in accounts payable of 22 million.

Here is the cash flow from investing for that three months:

Cash flows from investing activities:
Additions to other property, plant and equipment	(82,000	)	(13,000	)
Additions to oil and gas properties	(84,778,000	)	(33,285,000	)
Proceeds from sale of other property, plant and equipment	140,000		—
Proceeds from sale of oil and gas properties	—		1,384,000
Advances on note receivable to related party	—		(1,319,000	)
Contributions to investment in Grizzly Oil Sands ULC	(67,063,000	)	(4,878,000	)
Distributions from investment in Tatex Thailand II, LLC	200,000		—
Contributions to investment in Tatex Thailand III, LLC	(483,000	)	(895,000	)
Contributions to investment in Muskie Holdings LLC	(312,000	)	—
Contributions to investment in Timber Wolf Terminals LLC	(1,000,000	)	—
Contributions to investment in Windsor Midstream LLC	(7,021,000	)	—

Net cash used in investing activities	(160,399,000	)	(39,006,000	)

In those three months they invested $160 million but only had cash flows of $69 million and earnings of $26.7 million.

How did they finance this?

As noted the company had to finance $160 million of investing activities from only $26.7 million in operating earnings. This presents financing issues.

Firstly the company (as noted) ran up its accrued liabilities.

Then the company borrowed $10 million dollars.

But mostly the company ran down its cash holdings from $93 million to $13 million.

Where did those cash holdings come from?

The cash holdings did not represent past profits. What they were was proceeds from equity issuance. The company cash flow statement in 2011 shows $307 million in equity issuance - much of which has gone into investing in various quarters. The cash is now heavily depleted (note only $13 million is left).

If they intend on investing at these rates they will need to raise more capital.

What were the investments?

In the last quarter they invested $67 million in Grizzly Oil Sands. That is controlled by Wexford.

They also invested in Tatex, Muskie, Timberwolf and Windsor. All of these are Wexford entities.

Indeed they invested more than their entire revenue in Wexford Entities.

But they also added $85 million to oil and gas properties. A fair bit of that was with respect to the Permian Basin properties (they drilled wells and acquired acreage). Those assets are also being sold to a Wexford controlled entity. Other releases have envisaged a sale of that entity which will raise some cash allowing them to continue to invest.

I read many 10K and 10Q filings. Few are this fascinating.

John

Gulfport Energy and Wexford Capital (Part IV): What is left after Gulfport sells the Permian Assets to a Wexford Related party?

2012-05-22T14:10:00.000+10:00

In the last post I demonstrated that 12.885 million out of 19.367 million barrels of oil equivalent (BOE) in "proved reserves" was being sold by Gulfport to a related party of Wexford. These were the Permian Basin fields as per the table below.

															Proved Reserves
Field	NRI/WI (1)		Productive Wells (2)				Non-Productive Wells				Developed Acreage (3)					Gas		Oil		Total
Field	Percentages		Gross		Net		Gross		Net		Gross		Net			MBOE		MBOE		MBOE
West Cote Blanche Bay Field (4)		80.108/100		95		95		189		189		5,668		5,668			352		3,617		3,969
E. Hackberry Field (5)		79.424/100		30		30		93		93		3,291		3,291			226		1,606		1,832
W. Hackberry Field		87.5/100		2		2		23		23		592		592			—		76		76
Permian Basin		35.4/46.87		121		57		—		—		8,880		4,119			2,008		10,877		12,885
Niobrara Formation		39.7/47.9		6		3		2		1		3,954		1,977			26		500		526
Williston Basin (6)		2.8/3.3		6		.2		—		—		1,708		132			7		67		74
Overrides/Royalty Non-operated		Various		133		.2		—		—		—		—			3		2		5

Total				393		187.4		307		306		24,093		15,779			2,622		16,745		19,367

The table is from the 10K.

Given that most the reserves and most the cash flows of Gulfport are being sold to a related party it is worth considering the quality of the assets left. After all - if you are a Gulfport shareholder that is what you are buying.

Lets just take the Niobrara acreage.

The claim of half a million barrels of oil in the Niobrara raised my eyebrows because I thought most that acreage was locked up. Indeed it was this claim that attracted me (as a short) to Gulfport in the first place. I wanted to see what they based their claim of half a million barrels of proved oil on.

Here is what the 10K says about the Niobrara acreage:

Location and Land

Effective as of April 1, 2010, we acquired leasehold interests in the Niobrara Formation in northwestern Colorado, and held leases for 14,993 acres as of December 31, 2011. We are the operator on the acreage.

Area History

The Niobrara Formation is a shale oil rock formation located in Colorado, Northwest Kansas, Southwest Nebraska, and Southeast Wyoming. Oil and natural gas can be found at depths of 3,000 to 14,000 feet and is drilled both vertically and horizontally. The Upper Cretaceous Niobrara formation has emerged as another potential crude oil resource play in various basins throughout the northern Rocky Mountain region. As with most resource plays, the Niobrara has a history of producing through conventional technology with some of the earliest production dating back to the early 1900s. Natural fracturing has played a key role in producing the Niobrara historically due to the low porosity and low permeability of the formation. Because of this, conventional production has been very localized and limited in area extent. We believe the Niobrara can be produced on a more widespread basis using today’s horizontal multi-stage fracture stimulation technology where the Niobrara is thermally mature.

Geology

The Niobrara Formation oil play in northwestern Colorado is located between the Piceance Basin to the south and the Sand Wash Basin to the north. Rocks mainly consist of interbedded organic-rich shales, calcareous shales and marlstones. It is the fractured marlstone intervals locally known as the Buck Peak, Tow Creek and Wolf Mountain benches that account for the majority of the areas production. These fractured carbonate reservoirs are associated with anticlinal, synclinal and monoclinal folds, and fault zones. This proven oil accumulation is considered to be continuous in nature and lightly explored. Source rocks are predominantly oil prone and thermally mature with respect oil generation. The producing intervals are geologically equivalent to the Niobrara reservoirs of the DJ and Powder River Basins which are currently emerging as a major crude resource play.

Production Status

In the fourth quarter of 2011, our net production from our Niobrara acreage was 3,390 BOE, or an average of 37 BOE per day, 100% of which was from oil. From January 1, 2012 through January 31, 2012, our average daily net production from our Niobrara acreage was 41 BOE, 100% of which was from oil.

Facilities

There are typical land oil and gas processing facilities in the Niobrara Formation. Our facilities located at well locations include storage tank batteries, oil/gas/water separation equipment and pumping units.

Recent and Future Activity

We drilled three gross (1.5 net) wells at Niobrara during 2011. We have completed a 60 square mile 3-D seismic survey over our Craig Dome prospect, have received a processed version of the seismic and are selecting future drilling locations. We currently intend to drill five to seven gross wells at Niobrara during 2012.

Production - net - was 37 barrels of oil per day during the fourth quarter of 2011. In January they raised this to 41 barrels of oil per day.

The most recent 10Q filing contains this text.

Niobrara Formation. Effective as of April 1, 2010, we acquired leasehold interests in the Niobrara formation in Colorado and held leases for approximately 14,993 acres as of March 31, 2012. Aggregate net production from the Niobrara play during the three months ended March 31, 2012 was approximately 2,638 BOE, or 29 BOE per day. During April 2012, average daily net production in Niobrara was approximately 66 BOE due to completion of our 2011 drilling activity.

So for the first quarter the production fell to average only 29 BOE per day after averaging 41 BOE per day in January.

41 BOE per day in January implies production of 1271 barrels (approx) in January (being 41 BOE per day times 31 days).

We are told that production in the quarter was 2638 barrels. Simple arithmetic implies that production in February and March was 1367 BOE. Assuming 60 days in those months (29 in February, 31 in March) we get production of 22.8 barrels per day. A fairly sharp drop from 41 BOE per day in January. This may be a decline rate or it may be weather or other shut-in (we do not know). However shut-ins are more likely in January so decline is a reasonable guess.

After completing drilling activity for 2011 the production rose to 66 BOE per day.

These are not big numbers and production drops seem large. Indeed flow rates almost halved within the first quarter.

However the company states that 500 thousand barrels of oil in reserves are proven in this field.

It is a cliché that you only know what the reserves of an oil field were when the last barrel is produced. There are many fields that have surprised to the downside and some that have surprised to the upside.

I will leave it to my readers to judge - whether on the basis of the relatively small production and high decline rates demonstrated - they regard the 500 thousand barrels of proved reserves listed here as a solid number.

John

Gulfport Energy and Wexford Capital: Part 3

2012-05-22T01:04:00.002+10:00

Gulfport Energy - as I have shown in Part 1 and Part 2 - is intertwined with Connecticut based hedge fund group Wexford Capital. All their substantial assets are either jointly owned or operated or both by Wexford entities. The Chairman of the board of Gulfport is - at least in part - a Wexford man.

However Wexford have over the past few years dramatically reduced their holding in Gulfport. In the 30 April 2009 proxy Charles E Davidson (the principal of Wexford) spoke for 15,235,786 shares or just over 35 percent of the company.

After years of sustained selling by Wexford and sustained issuance by Gulfport, Wexford's ownership position is about two thirds lower.

Despite Wexford's reduced holding Gulfport remains tied to Wexford.

Wexford and Gulfport are still doing related party transactions. On 7 May (ie this month) they announced a transaction whereby they are selling their Permian assets in exchange for a stake in a soon-to-be-listed entity called Diamond Back.

There was no specific press release for this transaction - but it was announced via a long 8K. On May 8 they announced their quarterly results which briefly described this transaction. To quote the earnings release:

As previously announced, on May 7, 2012, Gulfport entered into a contribution agreement with Diamondback Energy, Inc. ("Diamondback Energy"), in which Gulfport agreed to contribute, prior to the closing of Diamondback Energy's initial public offering, all of Gulfport's oil and natural gas interests in the Permian Basin in exchange for (i) common stock representing 35% of Diamondback Energy's outstanding common stock immediately prior to the closing of its initial public offering and (ii) approximately $63.6 million to be paid to Gulfport upon closing of such offering, subject to adjustment. Gulfport's obligation to complete the proposed contribution is subject to various closing conditions, including Gulfport's satisfaction with the terms of the Diamondback offering.

The earnings release however does not include the observation that this is a related party transaction. You had to go to the 8K for that. Here is what the 8K says:

On May 7, 2012, Gulfport Energy Corporation (“Gulfport”) entered into a Contribution Agreement (the “Contribution Agreement”) with Diamondback Energy, Inc. (“Diamondback”). Diamondback was incorporated on December 30, 2011 for purposes of undertaking an initial public offering (“Diamondback IPO”) of its common stock, par value $0.01 per share (the “Common Stock”), pursuant to a Registration Statement on Form S-1 (Registration No. 333-179502) initially filed with the Securities and Exchange Commission on February 13, 2012. Diamondback has not conducted and will not conduct any material operations prior to the transactions described below. Prior to the completion of the Diamondback IPO, Diamondback will acquire all the outstanding equity interests in Windsor Permian LLC (“Windsor Permian”), which as of March 31, 2012, owned and operated approximately 30,025 net acres of oil and gas interests in the Permian Basin in West Texas.

Under the terms of the Contribution Agreement, Gulfport agreed to contribute to Diamondback, prior to the closing of the Diamondback IPO, all of its oil and gas interests in the Permian Basin in exchange for (i) shares of Common Stock representing 35% of Diamondback’s outstanding Common Stock immediately prior to the closing of the Diamondback IPO and (ii) $63,590,050.00 in the form of a non-interest bearing promissory note, which will be repaid in full upon the closing of the Diamondback IPO with a portion of the net proceeds from that offering. The aggregate consideration payable to Gulfport is subject to a post-closing cash adjustment based on changes in Windsor Permian’s working capital, long-term debt and other items referred to in the Contribution Agreement as of the date of the contribution. Windsor Permian is the operator of the acreage to be contributed by Gulfport. Gulfport’s obligation to make this contribution is contingent upon, among other things, the contribution to Diamondback of all the outstanding equity interests in Windsor Permian by DB Energy Holdings LLC (“DB Holdings”), Gulfport’s satisfaction with the terms of the Diamondback IPO and customary closing conditions. Under the contribution agreement, Gulfport is generally responsible for all liabilities and obligations with respect to the contributed properties arising prior to the contribution and Diamondback is responsible for such liabilities and obligations arising after the contribution.

In connection with the contribution, Gulfport and Diamondback will enter into an Investor Rights Agreement in which Gulfport will have the right, for so long as Gulfport beneficially owns more than 10% of Diamondback’s outstanding Common Stock, to designate one individual as a nominee to serve on Diamondback’s board of directors. Such nominee, if elected to Diamondback’s board, will also serve on each committee of the board so long as he or she satisfies the independence and other requirements for service on the applicable committee of the board. So long as Gulfport has the right to designate a nominee to Diamondback’s board and there is no Gulfport nominee actually serving as a Diamondback director, Gulfport shall have the right to appoint one individual as an advisor to the board who shall be entitled to attend board and committee meetings. Gulfport will also be entitled to certain information rights and Diamondback will grant Gulfport certain demand and “piggyback” registration rights obligating Diamondback to register with the SEC any shares of Common Stock owned by Gulfport.

The preceding descriptions of the Contribution Agreement and the Investor Rights Agreement are qualified in their entirety by reference to the full text of such agreements, copies of which are attached as Exhibits 10.1 and 10.2, respectively, to this Current Report on Form 8-K and are incorporated herein by reference.

Diamondback, Windsor Permian and DB Holdings are entities controlled by Wexford Capital LP (“Wexford”). Charles E. Davidson, the Chairman and Chief Investment Officer of Wexford, beneficially owned approximately 9.5% of Gulfport’s outstanding common stock as of March 13, 2012. Mike Liddell, Gulfport’s Chairman of the Board and a director of Gulfport, currently serves as the operating member and chairman of Windsor Permian and has an interest in DB Holdings. A special committee of the Board of Directors consisting solely of independent directors negotiated and approved this transaction on behalf of Gulfport.

The related party nature of this transaction requires (and is being granted) a committee of the independent directors.

How important are the Permian assets?

The last annual report (10K) contained a table with Gulfport's proved reserves by field:

															Proved Reserves
Field	NRI/WI (1)		Productive Wells (2)				Non-Productive Wells				Developed Acreage (3)					Gas		Oil		Total
Field	Percentages		Gross		Net		Gross		Net		Gross		Net			MBOE		MBOE		MBOE
West Cote Blanche Bay Field (4)		80.108/100		95		95		189		189		5,668		5,668			352		3,617		3,969
E. Hackberry Field (5)		79.424/100		30		30		93		93		3,291		3,291			226		1,606		1,832
W. Hackberry Field		87.5/100		2		2		23		23		592		592			—		76		76
Permian Basin		35.4/46.87		121		57		—		—		8,880		4,119			2,008		10,877		12,885
Niobrara Formation		39.7/47.9		6		3		2		1		3,954		1,977			26		500		526
Williston Basin (6)		2.8/3.3		6		.2		—		—		1,708		132			7		67		74
Overrides/Royalty Non-operated		Various		133		.2		—		—		—		—			3		2		5

Total				393		187.4		307		306		24,093		15,779			2,622		16,745		19,367

12.9 million of the 19.4 million barrels of oil equivalent in the proved reserves is in the Permian Basin. On this table Gulfport has sold the bulk of its proved reserves to a related party.

In their defence - after the transaction they own 35 percent of the related party which is lower but not massively lower than their prior ownership of the field. All that has happened is that they have lost control of the assets which they directly owned and are now owned by a Wexford entity. In this I presume the Wexford interests in those assets were also contributed and on similar terms. [I do not know - I am just giving Wexford the benefit of my doubt...]

Whatever: losing control means that they also lose control of the cash flows from these assets. Moreover as they own less than 80 percent of the assets if they get these cash flows out there will be a tax event. The 8K quoted above envisages a sell-down of the assets. This transaction does not make sense from a tax perspective unless that sell-down happens. So I presume a sell-down is expected.

As a shareholder it seems you are swapping productive assets you know for some cash which will (presumably) be used to develop other assets. Some of that cash only arrives when the IPO of Diamondback happens. There is nothing obviously wrong with that - but the related-party nature of the transaction does raise governance risks which make shareholders dependent on the non-executive directors to guard their interests.

John

Astarra Trio: report of the Parliamentary Inquiry

2012-05-21T08:41:00.000+10:00

This post is a victory lap on Astarra-Trio. If you are not interested in fraud in the Australian superannuation industry you might skip it.

Long-time readers of the blog will know that I am responsible for reporting to authorities the largest fraud ever conducted in the Australian Superannuation system.

For non-Australians I should note this is important. Australia has a privatised compulsory social security system where individuals are compelled to invest money in funds to fund their own retirement. Choice of fund is important (because returns are dependent on choice) but the investing population is usually unsophisticated in finance and often uninterested. Large pools of unsophisticated investors are - in my experience - always a magnet for scammers.

The fraud I reported was in a fund called Absolute Alpha - but it was only part of a larger network of fraudulent funds.

Spotting it required no genius on my part: I was tipped by a blog reader.

The regulators acted very promptly (within weeks) to my tip and closed the fund. I have described their behaviour as exemplary.

Several prominent people in the funds management market denied fraud - and one publicly argued that I was motivated by (a) greed* and (b) publicity for my fund.

Later one of the main perpetrators admitted guilt and is serving what I thought was as surprisingly short prison sentence.

Eventually there was a Parliamentary inquiry by the Joint Committee** on Corporations and Financial Services. The inquiry reported last week.

It is amusing to find this blog post written into the Hansard (permanent record) or the Australian Parliament. The inquiry was quite nice to me. They essentially accept all my propositions about how the fraud worked and described me as "persistent". I can't complain at any of the comments about me or this blog.

After reading the report (from Parliamentarians who had more resources and more time than me) I conclude I knew most - but not all - of what was going on. I don't find anything in the recommendations I strongly disagree with - but I can't see why the clients of ARP Growth should be treated any differently to the clients of (say) Tarrants - both were in self-managed super funds established in cookie-cutter fashion by their financial planners.

And I thank the Joint Committee for their observation that whilst the response to my letter was exemplary the persistence with which the regulators followed leads after an admission of guilt leaves a bit to be desired. In particular I have been surprised and disappointed that so little has been done to examine the ARP Growth Fund. The Committee expressed the same surprise.

Astarra-Trio may be a one-off. But somehow I doubt it. There is over a trillion dollars invested in superannuation schemes and almost all of the end-clients are way less sophisticated than the readers of this blog. I hope the Parliamentary Inquiry leads to a closer regulatory focus on ways of preventing theft in Superannuation. A honey-pot like the Aussie Super Pool is too attractive to fraudsters to leave so lightly guarded.

John

*I responded that it was hardly an insult to claim a hedge fund manager is motivated by greed. My clients expect nothing less. Controlled greed is what my clients pay me for.

**Joint Committee simply means that members come from both the Senate and the Lower House.

That is not a bubble. This is a bubble...

2012-05-19T11:08:00.001+10:00

I have just returned from visiting relatives in Vancouver. I mostly stayed in West Vancouver with my retired aunt and uncle but also stayed in outer-suburban areas with my police-officer cousin.

I was looking for a bubble - after all Vancouver is a notorious property bubble - but - speaking as someone from Sydney I could not see one. Everything was so cheap. Houses especially. Cars too.

A Mountie and his drug-rep wife had a material standard of living that would match a partner in a second tier law firm in Sydney. House prices seemed impossibly low.

The only place where my material standard of living was markedly higher than the outer Vancouver middle class was that I have a decent surf beach locally and the local restaurants and coffee shops are much better in Sydney. Also alcohol is cheaper in Sydney - which is in part taxes and in part protection. (Alcohol is much cheaper in parts of the USA.)

To offset the beaches and restaurants, my cousins had a ski resort up the hill. And food (other than dairy) was cheaper. Quality was high. Dairy seemed to be another industry-protection issue.

And housing was much cheaper and much higher quality.

I remember thinking that Sydney was in a bubble when it got as expensive as Vancouver now is. But then housing prices doubled. After that they seemed to drift upwards.

I have given up predicting the end of the Sydney property bubble. It will happen. It feels like it might happen now. But it has felt like that before. And before that. And before that.

I would rather be short Sydney property than long it (though my wife might object). And that stance has cost me money in the past.

There is a scene in Crocodile Dundee where a New Yorker pulls a switch blade on Dundee. He pulls out an Australian bush knife which is far more impressive.

That is how I felt about Vancouver. You call this a bubble? I am an Australian. I can show you a bubble. Vancouver - that is just kids having fun.

John

Gulfport Energy and Wexford Capital: Part 2

2012-05-18T13:30:00.000+10:00

The very long set of transactions entered into by Gulfport Energy with Wexford Capital was surprising to me as well as to a couple of readers.

One question though was (and I am paraphrasing): are these transactions large with respect to Gulfport Energy? Is that the reason you are short?

I can answer the first question simply: yes - related party transactions are important in Gulfport. That is easily seen by looking at their assets as mapped on their home page:

The company has interests in the Canadian Oil Sands, the Niobrara Shale, Thailand, the Permian Basin, Southern Louisiana and the Utica Shale.

Lets go through them individually.

The Canadian Oil Sands operations are held through Grizzly Oil Sands. The proxy tells us that Gulfport own a "24.9999% interest in Grizzly, a Canadian unlimited liability company, through our wholly owned subsidiary Grizzly Holdings, Inc. The remaining interests in Grizzly are owned by other entities controlled by Wexford."

The Niobrara Shale is "effective April 1, 2010 ... an area of mutual interest agreement with Windsor Niobrara LLC, which we refer to as Windsor Niobrara, to jointly acquire oil and gas leases on certain lands located in Northwest Colorado for the purpose of exploring, exploiting and producing oil and gas from the Niobrara Formation." That agreement provides that each party must offer the other party the right to participate in such acquisitions on a 50/50 basis. The parties also agreed, subject to certain exceptions, to share third-party costs and expenses in proportion to their respective participating interests and pay certain other fees as provided in the agreement." Gulfport is "the operator" of the Nobrara acreage - but the partner - Windson Niobrara is controlled by Wexford.

The Thailand assets are in two parts - Tatex Thailand II and Tatex Thailand III.

Gulfport have a 23.5% ownership interest in Tatex Thailand II, LLC. The remaining interests in Tatex II are owned by other entities controlled by Wexford.

Gulfport have a 17.9% ownership interest in Tatex III. Approximately 68.7% of the remaining interests in Tatex III are owned by other entities and individuals affiliated with Wexford.

Windsor, an entity controlled by Wexford, is the operator of all Gulfport's assets in the Permian Basin.

The Permian Basin Assets were (at year end) subject to an agreement with Windsor which provides that each party must offer the other party the right to participate in 50% of each such acquisition. The parties also agreed, subject to certain exceptions, to share third-party costs and expenses in proportion to their respective participating interests and pay certain other fees as provided in the agreement.

In other words Windsor owned 50 percent of these and operated them. There is an interesting post-year end transaction which may be the subject of another blog post.

The Southern Louisiana assets (known as West Cote and Hackberry) are not owned by Wexford but Wexford entities provide barging, drilling and pressure control services.

The Utica Shale assets are operated by Gulfport but like the Niobrara and Permian assets they are subject to a 50-50 sharing agreement with a Wexford controlled entity.

In other words Wexford is integral to the running or ownership or both of every asset controlled by Gulfport. The Chairman of Gulfport (Mike Lidell) cements this link. He is the operating member and in some cases an officer of many of the Wexford entities.

Wexford knows more than anyone else about this company

As we have shown Wexford is either a major owner or operator or supplier to every Gulfport Asset. The Chairman of Gulfport is also (at least in part) a Wexford man.

Wexford is a big fund - according to its website it has $5.6 billion under management.

It is worth knowing what Wexford is doing with their stake. The answer is selling. And selling. And selling some more:

Trade Date	Symbol	Company Name (Issuer)	Trade Type	Shares	Price ($)	Value ($)
2012-03-13	GPOR	Gulfport Energy Corp	Sale	245,000	32.80	8,035,020
2012-03-08	GPOR	Gulfport Energy Corp	Sale	329,670	32.53	10,723,835
2012-03-09	GPOR	Gulfport Energy Corp	Sale	370,422	33.17	12,285,416
2012-03-12	GPOR	Gulfport Energy Corp	Sale	150,000	32.43	4,864,200
2012-03-07	GPOR	Gulfport Energy Corp	Sale	381,968	32.32	12,347,115
2012-03-06	GPOR	Gulfport Energy Corp	Sale	50,000	31.23	1,561,700
2012-03-05	GPOR	Gulfport Energy Corp	Sale	59,000	32.18	1,898,797
2012-02-29	GPOR	Gulfport Energy Corp	Sale	17,000	34.50	586,585
2012-03-02	GPOR	Gulfport Energy Corp	Sale	17,200	33.75	580,534
2012-03-01	GPOR	Gulfport Energy Corp	Sale	459,000	34.11	15,657,408
2011-12-05	GPOR	Gulfport Energy Corp	Sale	1,150,000	27.84	32,016,000
2011-03-30	GPOR	Gulfport Energy Corp	Sale	2,760,000	30.56	84,345,600
2010-12-17	GPOR	Gulfport Energy Corp	Sale	3,910,000	19.40	75,854,000

Still they have 5.3 million shares left - and these have a not-inconsiderable value. Moreover almost all the sales have been at prices far above the current price. Their ownership position (including capital raises) has far more than halved.

I take a highly knowledgeable and very rich seller selling aggressively at prices around $30 as a good sell signal at prices around $30.

It is less good a sell signal where we are currently trading (at prices around $20). The reasons I am still short will need to wait for another post.

John

Wexford Capital and Gulfport Energy

2012-05-16T23:40:00.001+10:00

Gulfport Energy is a reputable Oklahoma based oil and gas company with widespread interests including in Canadian oil sands (via Grizzly Oil Sands) and in the Utica shale. It trades on the NASDAQ and has a market cap of a little over 1.2 billion dollars. The ticker is GPOR.

Wexford Capital is a reputable hedge fund and investment group based in Greenwich Connecticut with (according to the website) $5.6 billion in assets under management. That is more than 100 times what we manage.

The principal of Wexford is Charles E Davidson. He has a fine CV which I have cribbed from the website:

Charles E. Davidson, 59, co-founded Wexford in 1994 and serves as its Chairman and Chief Investment Officer. Mr. Davidson has primary responsibility for the overall strategic direction of Wexford’s investment activities and serves as the senior portfolio manager for the Wexford Spectrum Funds and the Wexford Catalyst Funds. From 1984-94, Mr. Davidson was a General Partner of Steinhardt Partners, L.P. where he was responsible for all fixed income arbitrage, risk arbitrage, private equity, distressed/bankruptcy and special situation investments of the multi-billion dollar hedge fund. From 1977-84, Mr. Davidson was employed by Goldman Sachs & Co. where he was the head of domestic corporate bond trading and proprietary trading. Mr. Davidson holds an MBA and a BA in economics from the University of California – Los Angeles.

Last week I read the proxy for Gulfport Energy which goes through the relationship with Wexford. There, properly disclosed, are many related party transactions.

The hedge fund I run is (apart from the management contract) involved in no related party statements so I find complex related party transactions surprising. However, as I said, they are properly disclosed. Here are a list of related party transactions from the last proxy:

... Based solely on Form 4 filed with the SEC on March 13, 2012 by Charles E. Davidson. Represents 5,336,526 shares of common stock held by CD Holding Company, LLC. Mr. Davidson is the manager and a member of CD Holding Company, LLC and the Chairman and Chief Investment Officer of Wexford Capital LP...

... We are a party to administrative service agreements with Stampede Farms LLC, which we refer to as Stampede Farms, Everest Operations Management LLC, which we refer to as Everest, and Tatex Thailand III, LLC, which we refer to as Tatex III. Under these agreements, our services include professional and technical support and the fees for such services can be amended by mutual agreement of the parties. Each of these administrative service agreements may be cancelled (1) by us with at least 60 days prior written notice and, (2) by the counterparty at any time with at least 30 days prior written notice to us and (3) by either party if the other party is in material breach and such breach has not been cured within 30 days of receipt of written notice of such breach. We did not provide services under any of these agreements in 2011 and received no reimbursements thereunder. Each of Stampede Farms, Everest and Tatex III is controlled by Wexford Capital LP, or Wexford...

... We contract with Athena Construction, L.L.C., which we refer to as Athena, to provide barge services in our West Cote Blanche Bay, or WCBB, and Hackberry fields located along the Louisiana Gulf Coast. For the year ended December 31, 2011, we paid Athena $3,389,000 and owed an additional $676,000 for such services at that date. Athena is controlled by Wexford...

... Effective March 1, 2008, Everest provides tax planning, preparation of supporting tax schedules and consultation services to us based on an agreed fee structure. The scope of such services can be modified with the mutual agreement of the parties. Everest is controlled by Wexford. We paid Everest $5,000 for these services in 2011.

Caliber Development Company, LLC, or Caliber, provides building maintenance services for our headquarters in Oklahoma City, Oklahoma. For the year ended December 31, 2011, we paid Caliber $20,000 and owed an additional $2,000 at that date. Caliber is an entity controlled by Wexford.

Great White Directional Services LLC, which we refer to as Directional, performs directional drilling services for us at our WCBB and Hackberry fields. Directional was an entity controlled by Wexford until August 24, 2011 when it was sold to an unrelated third party. Directional is no longer a related party. While still a related party, we paid Directional approximately $2,625,000 and owed an additional $1,133,000 for such services at that date.

Great White Pressure Control, which we refer as Pressure Control, performs services for us at our WCBB field. Pressure Control was an entity controlled by Wexford until August 24, 2011 when it was sold to an unrelated third party. Pressure Control is no longer a related party. While still a related party, we paid Pressure Control approximately $80,000. No amounts were owed to Pressure Control as of August 24, 2011.

Black Fin P&A, LLC, which we refer to as Black Fin, performs plugging and abandonment services for us at our WCBB field. For the year ended December 31, 2011, we did not pay any amounts to Black Fin and owed $436,000 to for such services at that date. Black Fin is an entity controlled by Wexford.

... We have a 23.5% ownership interest in Tatex Thailand II, LLC, or Tatex II. The remaining interests in Tatex II are owned by other entities controlled by Wexford. Tatex II holds 85,122 of the 1,000,000 outstanding shares of APICO, LLC, or APICO, an international oil and gas exploration company. APICO has a reserve base located in Southeast Asia through its ownership of concessions covering two million acres which includes the Phu Horm Field. During 2011, we received $870,000 in distributions from Tatex II.

We have a 17.9% ownership interest in Tatex III. Tatex III owns a concession covering approximately one million acres in Thailand. Approximately 68.7% of the remaining interests in Tatex III are owned by other entities and individuals affiliated with Wexford. During the year ended December 31, 2011, we paid $3,794,000 in cash calls to Tatex III.

We own a 24.9999% interest in Grizzly, a Canadian unlimited liability company, through our wholly owned subsidiary Grizzly Holdings, Inc. The remaining interests in Grizzly are owned by other entities controlled by Wexford. As of December 31, 2011, Grizzly had approximately 754,000 acres under lease in the Athabasca region located in the Alberta Province near Fort McMurray. Grizzly Holdings Inc. entered into a loan agreement with Grizzly effective January 1, 2008, under which Grizzly borrowed funds from us. Borrowed funds initially bore interest at LIBOR plus 4% and had an original maturity date of December 31, 2012. Effective April 1, 2010, the loan agreement was amended to modify the interest rate to 0.69% and change the maturity date to December 31, 2011. Effective October 15, 2010, the loan agreement was further amended to change the maturity date to December 31, 2012. Interest was paid on a paid-in-kind basis by increasing the outstanding balance of the loan. During the year ended December 31, 2011, we loaned Grizzly approximately $3,182,000 and recognized interest income of approximately $147,000. Effective December 7, 2011, Grizzly Holdings Inc. entered into a debt settlement agreement with Grizzly under which Grizzly agreed to satisfy the entire outstanding debt and accrued interest of $22,325,000 by issuing additional common shares of Grizzly with no effect to the ownership structure of Grizzly.

During the third quarter of 2011, we purchased a 25% ownership interest in Bison Drilling and Field Services LLC, or Bison, at a cost of $6,009,000, subject to adjustment. In April 2012, we increased our ownership interest in Bison to 40% for an additional payment of $6,152,000. The remaining interests in Bison are owned by entities controlled by Wexford, including Windsor Permian LLC, or Windsor. Bison owns and operates drilling rigs.

During the fourth quarter of 2011, we purchased a 25% ownership interest in Muskie Holdings LLC, or Muskie, at a cost of $2,142,000, subject to adjustment. The remaining interests in Muskie are owned by entities controlled by Wexford, including Windsor. Muskie holds certain assets, real estate and rights in a lease covering land in Wisconsin that is prospective for mining oil and natural gas fracture grade sand...

... Effective as of November 1, 2007, we and Windsor entered into an area of mutual interest agreement to jointly acquire oil and gas leases in the Permian Basin. The agreement provides that each party must offer the other party the right to participate in 50% of each such acquisition. The parties also agreed, subject to certain exceptions, to share third-party costs and expenses in proportion to their respective participating interests and pay certain other fees as provided in the agreement. During 2011, we acquired approximately 604 net acres from Windsor under the terms of this agreement for an aggregate of $1,102,000. Windsor is controlled by Wexford.

Windsor is the operator of all of our acreage in the Permian Basin. As operator of these properties, Windsor is responsible for the daily operations, monthly operation billings and monthly revenue disbursements for the properties in which we hold an interest. For the year ended December 31, 2011, Windsor billed us approximately $56,103,000 and at December 31, 2011, we owed $5,593,000 for these services.

Effective April 1, 2010, we entered into an area of mutual interest agreement with Windsor Niobrara LLC, which we refer to as Windsor Niobrara, to jointly acquire oil and gas leases on certain lands located in Northwest Colorado for the purpose of exploring, exploiting and producing oil and gas from the Niobrara Formation. The agreement provides that each party must offer the other party the right to participate in such acquisitions on a 50/50 basis. The parties also agreed, subject to certain exceptions, to share third-party costs and expenses in proportion to their respective participating interests and pay certain other fees as provided in the agreement. We are the operator of this acreage in the Niobrara Formation. As operator, we are responsible for daily operations, monthly operation billings and monthly revenue disbursements for these properties. For the year ended December 31, 2011, we billed Windsor Niobrara $6,642,000 and, at December 31, 2011, Windsor Niobrara owed us $3,557,000 for these services. Windsor Niobrara is controlled by Wexford.

In February 2011, we entered into an agreement with an unrelated third party to acquire certain leasehold interests in acreage located in the Utica Shale in Ohio. The agreement also granted us an exclusive right of first refusal for a period of six months on certain additional tracts leased by the seller. As of December 31, 2011, we had acquired leasehold interests in approximately 98,000 gross (49,000 net) acres in the Utica Shale in Eastern Ohio under these and other agreements for approximately $118,421,000. As of February 20, 2012, we had closed on additional acquisitions bringing our leasehold interests to approximately 107,000 gross (53,500 net) acres. We have commitments with various future closing dates that could increase our acreage position in the Utica Shale to an aggregate of approximately 125,000 gross (62,500 net) leasehold acres. Entities affiliated with Wexford, primarily Windsor Ohio LLC, or Windsor Ohio, participated with us on a 50/50 basis in the acquisition of the leases described above and, at December 31, 2011, held leasehold interests in approximately 49,000 net acres for which they paid approximately $118,413,000, excluding fees and expenses of $1,184,000 billed under the acquisition team agreement described below. We are the operator on this acreage in the Utica Shale.

Effective July 1, 2008, we entered into an acquisition team agreement with Everest to identify and evaluate potential oil and gas properties in which we and Everest or its affiliates may wish to invest. Pursuant to this agreement, Gulfport and Everest each agreed to form an acquisition team. Upon a successful closing of an acquisition or divestiture, the party whose acquisition team identified the acquisition or divestiture is entitled to receive a fee from the other party and its affiliates, if applicable, participating in such closing. The fee is equal to 1% of the party’s proportionate share of the acquisition or divestiture consideration. The agreement has a one-year term unless earlier terminated by either party upon 30 days notice.

From time to time, certain of our petroleum engineers provide services relating to evaluation of potential investments to Wexford and geological evaluations, seismic review and similar services to Tatex II and Tatex III. Wexford, Tatex II and Tatex III, respectively, have agreed to reimburse us based on the amount, scope and nature of services provided by our petroleum engineers to such entities. We did not provide any services under these arrangements in 2011.

As you can see there are considerable (properly disclosed) related party transactions with Wexford. Helpfully they include a summary:

Our Relationships with Wexford and its Affiliates

Charles E. Davidson is the Chairman and Chief Investment Officer of Wexford and he beneficially owned approximately 16.8% of our outstanding common stock as of December 31, 2011. Wexford is the manager of the Wexford-controlled entities described above. As manager, Wexford has the exclusive authority to, among other things, purchase, hold and dispose of the assets of each such entity. Mr. Liddell, our Chairman of the Board, is the operating member and, in some cases, an officer, of certain of these entities. All distributions made by these entities are first paid to the Wexford members in accordance with their respective ownership interests until they have received amounts equal to their respective capital contributions. Thereafter, distributions are to be made 90% to the Wexford members in accordance with their respective ownership interests and 10% to Mr. Liddell. Mr. Liddell is not currently entitled to, and has not received, distributions from any of these entities. All transactions between us and these entities are reviewed and approved by our independent directors.

All for thought and consideration of my readers.

John

Disclosure: We are short Gulfport Energy and have been for some time. We recently increased the position.

A stock called Comedy: the joke is on someone or other

2012-05-09T05:50:00.000+10:00

China Medical Technologies – a Chinese diagnostic, medical testing and genetic tools company which I am short – is possibly the strangest story in our portfolio. Here is the official “business description”:

China Medical Technologies, Inc., a medical device company, develops, manufactures, and markets immunodiagnostic and molecular diagnostic products. It uses molecular diagnostic technologies, including fluorescent in situ hybridization (FISH) and surface plasmon resonance (SPR), and enhanced chemiluminescence immunoassay (ECLIA), an immunodiagnostic technology in the development, manufacturing, and distribution of diagnostic products for the detection of various cancers, diseases, and disorders, as well as companion diagnostic tests for targeted cancer drugs. The company offers immunodiagnostic products, such as ECLIA analyzers and reagent kits for various clinical applications, including anemia, cardiac diseases, food safety, growth disorders, hepatitis, HIV, infertility, liver fibrosis, metabolic function, reproductive endocrinology, SARS, thyroid disorders, and tumors tests. It also provides FISH probes, a molecular diagnostic IVD reagent for the prenatal diagnosis of various genetic diseases; detection and prognosis of various cancers; and identification of cancer patients. In addition, the company offers HPV(human papillomavirus)-DNA chips, a molecular diagnostic biosensor chip, and SPR analyzers for the diagnosis of HPV infection and genotyping of HPV. It sells FISH probes and SPR chips to large hospitals through its direct sales force; and ECLIA reagent kits to small and mid-size hospitals through distributors. The company was founded in 1999 and is based in Beijing, the People's Republic of China.

The old ticker for the company was CMED but the company has been delisted, trades on the pink-sheets and has gone completely silent. They issue no SEC filings, pay coupons on none of their debt and do not answer questions from investors or regulators. The ticker is now CMEDY.PK.

According to their last published accounts they had roughly 100 million US dollars in cash, 20 million US dollars (118 million RMB) in quarterly pre-tax profits and were under absolutely no financial stress. They did however have $396 million US dollars in convertibles outstanding. At a high stock price those converts would convert. At a low price they would pay in cash so if the stock price was low enough the company might have had to refinance. However with 20 million per quarter in profitability it was hardly going to a problem.

Well it looked like it was not going to be a problem.

Some shortsellers thought that the company was using its cash to purchase assets from undisclosed related parties. More florid allegations went around but I have verified none of them.

Still the stock went down.

It went below the conversion price for the convertible which meant the above-mentioned covert would be due in cash. And then – strangely – the company put out a press release stating they intended to restructure this debt. Here is the key release:

BEIJING, Dec. 13, 2011 /PRNewswire-Asia-FirstCall/ -- China Medical Technologies, Inc. (the "Company") (Nasdaq: CMED), a leading China-based advanced in-vitro diagnostic ("IVD") company, today announced that the Company intends to implement a debt restructuring plan to improve its balance sheet. The plan may include, without limitation, a debt-for-debt exchange with existing holders of the Company's convertible notes maturing in August 2013 and December 2016, which may potentially involve holders receiving new debts with different interest rates, maturities and principal amounts compared to the existing debts or other alternatives to be agreed. Holders of the Company's convertible notes are requested to contact the Company's Cayman legal representative, Thorp Alberga at cmednoteholders@thorpalberga.com, which will collect contact information from such holders to facilitate their communication with each other to form a noteholders' committee to liaise with the Company.

This was truly remarkable. The company – at least on the stated balance sheet – had enough money to pay the debt (at least for a while). It certainly did not need to default on trivial coupons – but it defaulted.

Worse – it did not even tell anyone it defaulted. The bond trustee notified holders and that is all. And since then the company has been completely silent. It does not answer any questions from investors or regulators. It has just disappeared.

So what happened?

There are two hypotheses: (a) this really is a fraud or (b) this is a real company and the management are playing “silly buggers” to restructure the balance sheet to their liking (or even to steal the company).

A lot of people believe the second thesis. In this a solvent company simply stopped paying its debts and are hoping the convertibles covert (at $10 a share) and sell the stock in market (at $2 a share) to recover what money they can. And the insiders (who are talking to nobody) are buying the stock at $2 a share (perhaps with cash from the company) and in the end they will really own it.

There are other theses – including that the company is being taken private surreptitiously through a shadowy arrangement with a small American mutual fund group. This furthered the spike in the stock.

Read the Yahoo! chat board and you can have another twenty theses some implying honest management and lying short-sellers and some implying awful things about the management. There is very little way of telling them apart. Management answer no questions so all speculation is in a knowledge vacuum.

We were short but we were worried that this might be the good Chinese company thrown out by a fraud allegation - we are always wary of being wrong. And the stock was going up which is never comfortable for a short seller.

So whilst the stock hung in the air much the same way bricks don't we hired someone with genuine expertise in diagnostic tests to look at the technical specifications of the medical tests they had on their website. (Our expert can read Chinese.)

Here was their response:

They have three product lines: ECLIA, FISH, and SPR. I am a bit busy doing other stuff, so I will do this in three parts, one product line per part. Here is the first part on ECLIA:

ECLIA instrument and assays are proprietaryECLIA Product brochures have no product specification Sensitivity of instrument is stated as 10^-19, but no units givenCan’t find any patents that belonged to the company

ECLIA is what they call Enhanced chemiluminescence immunoassay. The company said it is a closed system, i.e. proprietary instruments and diagnostic assays. The assays cannot be used in 3rd party instruments, and the instruments cannot be used for 3rd party assays. This is very strange because cost is important in diagnostics based on chemiluminescense technology. A closed system means higher cost, smaller volume, but you hope to make up for it on price, i.e., differentiate products based on quality. Indeed, they claim that their instrument is very sensitive, 10^-19. But 10^-19 of what? They don’t specify the unit. Regardless, whether it’s molar or ng/ml, 10^-19 sounds very impressive. However, I am used to nano or pico scale, and 10^-19 is one million times more sensitive than pico scale. This seems impossible. Not only impossible technically, but also business wise – what diagnostic applications would need this kinds of sensitivity? I can’t think of any. Also, I don’t think sensitivity matters for the type of assays they sell.

Chemiluminescence immunoassay is the technology found in pregnancy tests sold in drug stores. This is an old and cheap technology. In general, you use this technology to get yes or no answers quickly and cheaply. The sensitivity of chemiluminescence immunoassay is usually below 0.5ng/ml, i.e., already very sensitive. Regardless, for in vitro diagnostics, most of the technology should be in the assays, not in the instruments. And here is where I found strange - the company does not have product specification for its assays on the web. On the other hand, lots of Chinese instrumentation and diagnostic assays products sold on Alibaba show no product specification at all. The only immunoassay technology that is known for its sensitivity is radioimmunoassay, but it is a niche product specific for detecting allergen for allergy diagnostic. If CMEDY’s technology is real, then it's ECLIA products have a very small niche and it probably has no sales - the company has only one test for allergy – total IgE.

We remain short this stock. CMEDY is a good ticker – add an 0 (which is where I think the stock will wind up) and you get COMEDY. That is good for a laugh.

John

The question I wanted to ask at the Berkshire meeting

2012-05-08T01:07:00.001+10:00

I never got to ask a question at the Berkshire meeting. I was a little awed and did not even ask until about 2pm (which was silly). There was a lottery ticket system to determine who got to ask a question anyway.

So here goes (and for the most part I genuinely do not know the answer).

Insurance companies sell promises to make good real goods and services some time in the future for cash now. For example they promise to pay someone's medical expenses or a nursing home bill say 10 years after a premium has been collected.

They mostly hold the cash receipts in cash and bonds. Berkshire also use some real assets (eg railways) and many banking stocks.

Because insurance companies are short real goods and services and long cash and other nominal assets they negatively affected by inflation. Long tail insurance companies are obviously worse hit with inflation than short tail companies.

Can you run through the major Berkshire insurance businesses (GEICO, Gen Re, Ajit Jain's business and others) and tell us what damage inflation will do and why?

Answers are gratefully accepted - especially from Uncles Charlie and Warren (who I somehow doubt read this blog).

John

PS. I should disclose because people are doubting it - that Bronte Capital is LONG Berkshire stock.

J

Thoughts on the Berkshire meeting and a comment on long term care reinsurnace

2012-05-06T08:31:00.000+10:00

I am in Omaha and have just been to the Warren and Charlie show. It has been on my "to do" list for my whole adult life and I am strangely disappointed.

It is of course blasphemous to be disappointed in Charlie and Warren. These octogenarians could teach me plenty - they just did not. It was annoying to be in the presence of people so smart and to learn so little.

I have read various notes from the meeting for almost twenty years so I had a fair idea what to expect. I could expect - questions on politics and economics, questions from young people wondering what to do with their life and questions from hedge-fund managers using 25 thousand rich people in a room as an opportunity for self promotion.

I got all this - and for the most part I got the usual homily answers. (The same questions were asked last year and the year before and the year before that. Answers can be got from meeting notes.)

This year we got multiple questions from hedge fund managers who were concerned about the stock price. Charlie Munger in frustration tartly observed that if one (nameless but well known) hedge fund manager was that concerned about short term matters he wasn't really welcome in this room. This got general applause but could (like many of Charlie's answers) be a little more diplomatic.

But with the above exceptions the questions were better than I expected. Much better. We had serious questions from competent Wall Street analysts who mostly asked about insurance, underwriting and regulatory issues - issues that cut to core of what Berkshire is and Berkshire's ability to route money to the parent company (where it can be used unencumbered) and to pay insurance claims. The detailed answers to these questions were largely squibbed.

One analyst for instance made the obvious observation that the organizational structure is "challenging" and wondered why the railway (BNSF) was owned by a regulated insurance subsidiary. Charlie and Warren squibbed it - arguing that BNSF provided more resources for paying claims - noting roughly $5 billion in pre-tax profits. But throughout the meeting Warren argued that one advantage of BNSF was that it was going to be allowed to invest vast sums (far in excess of depreciation) at acceptable regulated returns. In other words BNSF is going to absorb cash. How does this mean the insurance sub is going to have more cash to pay claims? Can claims be paid in steel rails or railway bridges?

This wasn't an atypical squibbed answer. Warren (correctly) argued that General Re was a good asset now but that previously it lost its way. Charlie wasn't going to let Warren get away with this - it was thoroughly lost when Berkshire purchased it (and paid a huge price). However the details of how General Re was brought back into order were simply glossed over. Warren observed that Gen Re had a very nice life reinsurance business. That surprised me. Swiss Re has a sort-of-OK life reinsurance business but life reinsurance is a business that has produced a few disasters one of which I followed closely*. I was struggling to understand what made the life reinsurance business a good business.

Warren also noted - as a throwaway - that they had a long term care reinsurance business that he wished they had less of. Again there was no explanation as to why. But this time it is inside my field of competence so I am going to explain myself.

The disaster of long term care insurance

Long term care insurance has bankrupted almost everyone that ever touched it. It is the insurance against the need to go into a nursing home and it has mostly been sold by insurance agents on commission.

Here is what a commissioned agent does.

They make friends with people who run nursing homes.

When the kids (now middle aged) visit a nursing home they might put their (elderly) parents into the insurance broker is notified. The insurance broker then sells them a policy for their parents.

Of course the policy is going to be used. The people who buy long term care insurance are precisely the people who are going to claim. It is a disaster.

Eventually the policies become so expensive (to cover the losses) that people who won't claim never buy a policy. Adverse selection becomes total.

Long term care insurance is the worst business I have ever seen.

Warren of course never told us that - but somehow he wound up re-insuring it.

I guess he did not want to explain his stupidity.

But then long term care doesn't need to be that awful. Indeed there is (at least) one company that does it well.

That doesn't make long term care a good business - but it might make it an acceptable business.

That company is (and this will be a surprise to many of my readers) Genworth. The same Genworth that was a spin-out of crappy long-tailed insurance businesses from GE Capital. It includes a mortgage insurance company (with what is probably a toxic Australian exposure) and a long term care business.

Here is what they do to make the long term care business acceptable.

They employ a sales force of 60-65 year old people on salary not commission. Because they are on salary not commission they have no incentive to write bad risks. They do not troll for business in nursing homes.

This sales force visits the home of leads and has a cup of tea or coffee and a social chat. They might spend twenty minutes having a chat.

They will find out what the lead's husband or wife is doing.

They will find out whether the lead is doing the New York Times crossword or reading sophisticated books.

And whether they play golf or do some exercise.

They will look for pictures of the grandchildren and ask questions about them.

They will observe and ask about the pile of toys and children's games in the corner.

And only then will they ask anything that looks like an underwriting question but they will have already decided whether to underwrite the business.

Here is what is going on.

People who have stable relationships into old age tend not to wind up in nursing homes. They look after each other. Singles are the biggest risk and asking about a spouse is the critical question.

Doing the New York Times crossword or reading sophisticated books indicates no Alzheimer's disease. That removes another major insurance risk.

Golf suggests some physical fitness - and removes more risk.

The children's toys however are - after a solid marriage - the next largest risk mitigating factor. If the grandparents look after the grandchildren that creates a reciprocal obligation. The children are far less likely to put granny in a nursing home if granny is a part of their own kid's lives.

Warren knows all this. He knows why some insurance businesses are better than others. He knows why their life reinsurance business is good (I have no idea). He knows why their long-term care reinsurance business is bad (and after this post so do you).

But Warren told us surprisingly little. And for that I am disappointed.

John

*I was once obsessed by the collapse of Annuity and Life Re.

Post script: in all except a very bad year or a very high cap-ex year the depreciation plus profits of BNSF will probably be less than cap-ex so there are likely to be distributable funds. One exception may be if a catastrophe removes many of the bridges or damages the rails or closes the line for an extended period. That however may well be a big claims year for the insurance company so the situation can still be problematic.

Huabao Suspends Trading After Falling on Short-Seller Report

2012-04-25T20:16:00.001+10:00

Huabao - a Chinese flavours and fragrances company in Hong Kong - has suspended trading after falling on a short-seller report. To quote a Business Week article:

Huabao International Holdings Ltd. (336), a maker of flavors and fragrances used in cigarettes, suspended trading in Hong Kong after the stock plunged on a short-seller report that questioned its finances.

Huabao fell 8.1 percent to HK$3.98 at the close in Hong Kong yesterday after short seller Anonymous Analytics said the company “reports absurdly high margins, which industry sources say should not be possible.”

The company didn’t give a reason for the suspension. In a Hong Kong stock exchange filing late on April 24, Huabao said it wasn’t aware of any reasons for the changes in its share price and trading volume.

Readers of this blog should be familiar with the stock as I blogged about it here. I also blogged about the (now in excess of a) billion US dollars the CEO had cashed out and the derivative transactions that she had used to do so.

The suggestions in my blog post - and a few other things - were covered in the short-seller report.

John Hempton

Disclosure: We remain short this company - albeit in modest quantity.

Do I have any blog readers in Istanbul?

2012-04-18T00:21:00.003+10:00

Just asking. I am visiting.

Send me an email through the blog.

Daddy you are more evil than I thought

2012-04-16T03:55:00.000+10:00

It is the holiday part of the trip and I was strolling through the back-lot footpaths of Venice with my twelve year old son. We were doing out best to get lost (surprisingly easy) and I had given up worrying that my wife had (dangerously) gone shopping.

It was four hours chatting to the boy about business and history and life without the interruptions of computers, phones or video games.

We talked about the trading history of Venice, the closure of the Venetian constitutional system (La Serrata of 1286 to 1297) and the subsequent relative decline. We talked about the expenses of the nearly endless series of wars against the Ottoman empire.

We even mentioned the rise of double-entry accounting. We got as far as the collapse of the Venetian State at the hands of Napoleon.

We also talked at length for the first time about our business. We run a hedge fund. Our job is simple: make rich people richer through investing, trading in financial markets.

Half of that is relatively easy to explain: we buy shares in good companies. My son wanted to know why I was not interested in buying Facebook (he thought the shares are going up). I told him that it had 4 billion in revenue, 1 billion in profits and a market cap that was likely to edge 100 billion. The numbers are from memory (I am on holidays). That seemed expensive. However it was only about $200 per regular user which does not seem so expensive. I did not think I could analyse it well. This was the beginning of a discussion about price.

But then the area our fund is best known for came up. I am a short seller.

I went through the mechanics of short-selling. I borrow a share from a broker. I sell it in the market. If the stock goes down I get to buy it back for less than I sold it. I repay the loan by returning the share and I keep the profit. I explained it does not work so well when the stock goes up.

Then I got to the nub of the issue: I am a short-seller of frauds and stock promotes. I look for people in the stock market who have fake accounts and who are stealing from gullible shareholders (also known as marks, dupes, fools, day traders or mutual fund managers). There is a torrent of money being ripped off (many billions of dollars for instance in the case of the Chinese frauds a surprising amount of which came from Fidelity). Through short-selling I stick up my sail on my little boat in the hurricane of theft and some of that loot drops into the cabin.

He asked me how I find all these fake accounts and fake companies and I told him a few of our methods (we have many).

He asked if I ever dobbed the scammers in to regulators and I said I did sometimes but it was mostly not a satisfactory experience. To be a good short-seller I only need to be right about 90 percent of the time. If most the companies I short-sell have fake accounts I will do fine. However if I dob them into regulators I need to be absolutely right in that it does not bode well to dob an honest person into the authorities. So mostly I keep my gob shut and express my opinion (and it is an opinion) in a bet in the financial market.

Moreover talking about which stocks you think are frauds is a dangerous thing. Regulators sometimes (even foolishly) have been known to investigate short-sellers for telling the truth. (Being short Lehman Brothers and vocal about it was a good way of getting an SEC investigation for talking truth to power.) Also crooks sue short-sellers giving you nasty and expensive legal bills.

Silence is altogether a better strategy.

But then he came to the nub of the issue. The easiest scammer to find is a repeat offender. We actively seek out people who promote dodgy stocks and who who are repeatedly involved in dodgy companies. The slogan is “once a scumbag, always a scumbag”. That slogan is probably not strictly accurate - but we only need to be right 90 percent of the time to be fantastic at this business – and the recidivism amongst scammers is surprisingly high.

In that sense long sentences for people like Bernie Ebbers are not in my interest. I would prefer slime-bags to be back-in-business rather than in prison. More opportunities for me.

So, perceptively my son asked whether it was in my interest to dob scammers into regulators – he asked whether the reason we did not do it much was because of the reasons stated above or because we liked the scammers to be free and profitable. Alas – and I had to confess it – at least part of it was that being a successful short-seller required that regulators were inadequate to the task of policing fraud.

I did not talk about this with him – but it is becoming harder under Mary Schapiro. The SEC is getting better at their job – and that is not good for me. It would be better if regulators stayed hopeless. Alas they are getting better.

So, says my son asks you like nasty people to steal from poor investors, mutual funds (and he did not say pension funds for school teachers) so that you can join them in taking the loot by being a short-seller – and you don't want the regulators to do anything about it because there are more opportunities for you?

Sheepishly I confess yes.

And he says with a mixture of admiration and horror: “daddy you are more evil than I thought”.

John

PS. A long time ago I promised Felix Salmon an economic defence of short-selling. I did not deliver – but it is sort of written in my head. I think I owe it to my son too.

Lessons in my laundry: Italian edition

2012-04-13T18:30:00.000+10:00

On my travels I found myself in a fine hotel in Central Milan. I came in about Midnight the previous night from London (courtesy the atrocious service of Easy-Jet*).

At 6.15AM I was up for my morning meeting - via a fast-train to Bologna. My shirt was clean courtesy the expensive London laundry. I just wanted an ironing board to press out the wrinkles.

There was not one in the room - so I rang reception. I asked them to bring one up. They said "impossible" which I found peculiar. An ironing board is a pretty standard service in a 4 star business hotel.

Then they explained that they could not get one before 7.30 (which was just before my train left). I said this was a bad fail for a business hotel.

Then they said something that was so stereotypical Italian it left me breathless. They told me it would be against the law to bring an ironing board to my room before 7.30 am.

I told this to my Bologna business contact and he scoffed. Of course somewhere in the 10 million lines of Italian code there is - of course - something that talks about ironing boards. Dysfunctional government (at least by the standards of OECD countries) is an iconic feature of Italy - but this was not government as a problem - it was government as an excuse.

At least Easy-Jet don't blame the government for their bad - even rude - service.

John

*If anyone knows why European discount carriers are so horrible but Southwest (surely a similar model) is so pleasant (at least in a relative sense) let me know. In the USA I will fly Southwest in preference to any other airline. In Europe I am learning to avoid the discount airlines.

-------------

A post script is warranted: Part of my dislike of Easy-Jet had to do with a ridiculous overcharge of GBP12. Trivial really. However when I complained at the counter the discussion had the tone of "I can see you are right but our computer won't let me refund the money so sorry". Silly stuff that indicated process over service. And I had 90 minutes at an airport and was frazzled. Not a good combination. I did not raise my voice - just walked away frustrated.

In frustration I wrote a (nasty) letter to them. I do not think they linked me to this blog - but they refunded the 12 pounds. I think that marks them as several steps better than Ryan Air. I have not quite forgiven but I think I am prepared to give them another go.

Lessons in my laundry: Hong Kong edition

2012-04-12T17:39:00.000+10:00

I do irregular (but extended) business travel. (It comes from living in Australia – when you travel it is usually more than a week.)

And so I find myself needing to wash and iron business shirts and press a suit. Nothing complicated – but strangely the price and procedure changes by country. In New York I usually stay in Brooklyn and my walk to the subway takes me past a Chinese laundry which is breathtakingly cheap – my bag usually costs under $12. That is about a quarter what I would pay in Sydney (which is an expensive city for almost everything) and a third London. Brooklyn seems cheaper than other US cities.

This low-cost laundry (clearly a benefit to me) is made possible by a near-sweatshop centralised Chinese laundry where (immigrant) workers work hard for what may or may not be minimum wage.

When I wrote a post about that I was criticised for daring to state the obvious about income inequality in the United States. It is a taboo topic. In my defence several readers noted that investment bankers regularly press their own shirts in London. I certainly do in Sydney.

When I stayed in a friend's house in Chicago I discovered much to my surprise they did not have an ironing board. I thought it worth a blog post. And whilst the underlying tone was that income inequality was not the finest attribute of a society I have to say it is not entirely a bad thing. The couple I stay with in Chicago are a monstrously successful husband and wife team with children. Very few married women with children pull that off in Sydney – and the reason was obvious. The wife's work life (high profile but only moderately remunerative) relied more than a little on the two nannies and the implied low-wage workers (such as the staff at the local laundry) who relieved her of the mundane house-work that fills many (mostly female) lives in Australia.

This was feminist achievement made possible by income inequality. But it was achievement at a very high level and the USA is better for it.

This trip I stayed at a friend's apartment in Hong Kong. Nice place – not huge – but half-way up the Mountain on Hong Kong Island with an expansive view of skyline (when you can see through the pollution).

I asked to borrow an ironing board. My friend said he could do better. He knocked at a small door past the closet next to the kitchen and out popped a Filipino house-keeper maybe 20 years his senior. She cheerfully laundered my clothes and left them neatly pressed. She also made me breakfast, cleaned up my dishes and made my bed when I went to work.

I made a point of trying to work out her story. She had been a migrant worker throughout her life – mostly in Hong Kong but also in Dubai (which she found harder). She was thinly educated but thought her children (who she had spent years away from) were better prepared than her. The reason for migrant work was to educate her children (though I know nothing about their prospects – the Philippines are not a highly functional place). Unlike Harry Potter she did not show any unhappiness in living in the “cupboard under the stairs”. Instead it was a step-up for her and (especially) for her family. And it was better than Dubai.

But it made me deeply uncomfortable. Migrant workers are a profoundly anti-democratic institution – they provide a class of very-low income people who don't vote. The ethos of democracy is something burnt into my consciousness. In this ethos we are “created” equal (and thus have an equal vote) and dint of luck and hard work (or coming from the right womb) produce inequalities (some deserved, some otherwise). But the vote (hopefully a secret ballot) is one of the great equalisers – and acts to create a more harmonious society (albeit one that will interfere with income distribution to some extent). The woman who cheerfully lived in the cupboard under the stairs challenged what I thought was right in the world.

But then I was in Hong Kong (that is China) and another low-wage worker who does not vote in China seems – well – somewhat irrelevant. And my world view was out of place. Moreover the woman's children were clearly better off for her migrant work. And the Philippines would be a true basket case without remittances.

And low-income workers are a gift to those who get to employ them. They make the Feminist achievements of my above-mentioned Chicago friends possible. They can free productive people to work on things that were productive.

And that was clearly the case for my friend – consciously trying to pick up additional commercial languages (think India), improve his computer processing skills (python) and read a book per week. His ambition to build himself into as fine a thinker (and with as many diversified mental models) as Charlie Munger. Human capital development made possible by the profoundly undemocratic institution of migrant work.

But that was not the only thing people do with their wealth in Hong Kong. Hong Kong Island has become a pastiche of office towers for financial businesses and shopping malls selling the global standard set of luxury goods. Interspersed amongst that are stylish but ultimately vacuous bars where you can get wasted in the time you would have otherwise spent ironing your clothes and doing the dishes. It is not far (just a subway) from Kowloon where you can experience the smells and sounds of Asia – but they joke on Hong Kong Island that you need your passport to go there.

This is a world very different to mine – with some amazingly productive people – their productivity made possible by the institutions of China. Interspersed amongst that the most dilettante hedonistic lifestyle of an elite who can think of nothing better to spend their loot on than Swiss watches and French Brandy.

Whatever: I am going to make a confession. I liked having someone launder my clothes and the stylish bars are very cool. Freeing up all that time to read an extra book per week – that would be very cool too.

John

Phil Falcone tries to rip off taxpayers

2012-03-20T08:57:00.001+11:00

This is from the guy who took a $113 million loan from a fund he managed for his clients.

His vehicle - Lightsquared - owned a bunch of satellite spectrum. It was zoned for satellite - allowed to be used for low powered devices that did not interfere with users of adjacent spectrum.

He got its use changed - so that he could use it for high powered devices - that is a terrestrial LTE network. There was a condition. That his devices did not interfere with adjacent devices - namely GPS receivers.

This condition was clear right from the start.

Tests were conducted to see whether Phil's network would interfere with the GPS system.

And it did. And how. The devices could jam GPS at many miles range.

OK - so Phil was not allowed to build his LTE network.

He still owns satellite spectrum. What he started with. The FCC took nothing from him.

But he wants the FCC to give him spectrum he is allowed to use - spectrum more valuable than the stuff he previously owned.

“They can’t just leave us without some alternative to build a network,” said Jeff Carlisle, Lightsquared's EVP for regulatory affairs and public policy, at a briefing with media on Friday.

Yes they can. And they should. Of course I could lobby the FCC to get them to give me 10-20 billion dollars worth of spectrum I am not entitled to.

I could. But I am not that brazen.

If the government wants to give away that much spectrum they should auction it and the money should be used for the benefit of all taxpayers (say by paying off debt).

Make no mistake about it. If you are an American taxpayer Phil Falcone is trying to loot assets that rightly belong to you.

You should not let him. And you should despair if he gets away with it.

John

What mega-fund managers care about

2012-03-13T11:50:00.000+11:00

I just received a survey request from the Economist Intelligence Unit on behalf of State Street Corporation. The target group was clearly mega-fund managers – a group of which I am not a member.

However the questions (and choices offered) were an insight into the concerns of mega-fund managers – concerns that are generally not shared by the clients.

The opening question set the tone:

1. What are your organisation’s total global assets under management in US dollars?

Under $50 billion
$50 billion to $99 billion
$100 billion to $499 billion
$500 billion to $999 billion
$1 trillion or more

Pretty close to the entire hedge fund community has to take the first choice here. David Einhorn – first choice. Any of the Tiger Cubs. First choice. Even big-name mutual funds are in the first bucket. This was not a survey that was going to be of any relevance to me.

Question 6 revealed the bulk of the rest of the study:

6. In your opinion, which of the following is the most important factor driving decisions among institutional investors in today’s environment? Select one.

Yields
Diversification away from mainstream asset classes
Regulatory complexity / uncertainty
Risk aversion
Other, please specify

Kind of amazing. Performance is not listed as even a possible important factor driving decisions among institutional investors. Let me be blunt: the only things Bronte (or any decent small fund manager) sells are “risk management” and “performance” in that order. Not risk aversion. Fund managers are paid to take sensible risks – and to manage money. If risk aversion is your thing I can produce you a fund with a Sharpe Ratio over 5. I will just invest the money in 28 day Treasury paper. I put risk management first because it doesn't matter how good your performance is if you take stupid risks one day you will get lanced.

The growth aspirations of large fund managers clearly follow their performance:

8. What are your organisation’s expectations for increasing assets under management over the next 24 months?

0%
1% - 3%
4% - 7%
More than 8%
Don’t know

Where are the 50-100 percent growth option that a small successful hedge fund manager might have. These guys live in a world where 8 percent growth over two years is a lot to hope for. A small fund manager hopes to get a multiple of that growth in assets under management just from performance. It is not guaranteed by any stretch. However large asset managers are living in a world of very low expectations.

Half a dozen of the next questions were about regulatory environments and the effects they will have on the business. These were interposed with questions about computer systems (clearly necessary to meet the regulatory issues). However this question gave the game away:

15. What are the greatest data management challenges to the asset management industry today? Select all that apply.

Achieving sufficient scale with in-house systems
Providing a high level of detailed and quality data to clients
Safeguarding investor data
Providing accurate data to regulators and auditors in a timely fashion
Don’t know

Collecting and managing the data on the range of investment choices was not even a concern. Nor was any data necessary to assess risks. Bizarre.

At least on the next question you got to write in the issue that really matters:

16. Which of the following will contribute to your organisation’s ability to expand globally over the next 12 to 24 months? Select the top two.

The strength of our infrastructure
Relationships with key market participants
Brand recognition
Competitive advantage in niche markets
Other, please specify
We currently have no plans to expand globally

What will enable Bronte to expand globally over the next 12-24 months? What about any small asset manager? One word answer: performance. Fund managers - especially small ones - live or die by it. Our most sophisticated customers when they ask us questions ask us almost exclusively about risk management - so if we want to grow amongst those people we need to have a demonstrated culture of risk control and good performance. But still the thing that makes an asset manager grow is performance - if only because 20 percent returns increase your funds under management by 20 percent even if you have no net flows.

Sometimes, looking at some stock in some company I think is fraudulent or insolvent I wonder what goes through the minds of the large institutional shareholders.

But maybe I am just attributing to them motives that they don't have. Maybe I just assume they want to actually manage money (rather than manage regulators and sell product).

Just maybe. Alternatively State Street (who commissioned this survey and whose business is back-office and custody) have no idea of the concerns of their clients.

John

Some hope in American politics

2012-03-12T20:10:00.000+11:00

I wrote a post yesterday which impinges on American politics. I simply observed that the alleged New York Madam who is being locked in solitary for failure to find $2 million in bail money was being denied her constitutional rights.

(I also criticized the recent executive grab for power by Eric Holder.)

I said I thought that the State abrogating Constitutional Rights was an unfortunate trend.

What pleases me is that (with the exception of a second amendment fundamentalist who objected to my off-hand assertion that the provision was antique) I have had almost universal agreement with this observation from both the left and the right.

I have gun-toting law-and-order right wing readers. They agree.

I have liberal readers. They agree.

I have libertarian readers. They agree.

I haven't seen this much agreement in any US political matter for a long time.

That is hopeful.

John

PS. As far as I know I don't have many Christian-fundamentalists who want a Christian State type readers. As I was standing up for the constitutional rights of a woman who is alleged to have provided women for prostitution I suspect there is a fracture line there. I did not see that in comments or emails received.

When did the US constitution cease to matter? (Oh, and a comment on the alleged New York Madam.)

2012-03-11T15:56:00.000+11:00

I am a resident of a country without a bill-of-rights in our constitution. Whilst I think some of the rights are antique (second amendment, implied right to privacy in the fourth amendment which looks very difficult in the era of "digital papers") it is - I think - an improvement on our system.

That said, it is only an improvement on our situation if the constitution is not ignored.

This week we have seen an amazing power grab by the US Attorney General. To quote Eric Holder:

“Due process and judicial process are not one and the same, particularly when it comes to national security. The Constitution guarantees due process, not judicial process.”

Here is what the constitution says (Fifth Amendment):

No person shall be held to answer for a capital, or otherwise infamous crime, unless on a presentment or indictment of a Grand Jury, except in cases arising in the land or naval forces, or in the Militia, when in actual service in time of War or public danger; nor shall any person be subject for the same offense to be twice put in jeopardy of life or limb; nor shall be compelled in any criminal case to be a witness against himself, nor be deprived of life, liberty, or property, without due process of law; nor shall private property be taken for public use, without just compensation.

I have - for the benefit of the Attorney General - highlighted the relevant section.

Incidentally I have quite a deal of sympathy for extra-judicial execution of a dangerous criminal. "Wanted, dead or alive" posters have been part of the American mythology for a reason. But I gather there was a valid arrest warrant for the person and if the person surrendered there was a legal process. These are I presume "processes of law" rather than (say) a process of the executive. The executive claiming that their process is sufficient to execute someone is - politely - novel.

But it is not the big cases that worry me about America. Its the little cases because through the little cases you can see the erosion of the liberties that made America great affecting ordinary citizens.

Linked is the New York Post article about Anna Gristina - the alleged New York madam with a roster of high class clients. Sure I was reading it for salacious details of who the clients might be. However I found myself getting more annoyed at the process.

You see she is innocent until proven guilty - and she is being locked up in solitary confinement on Rikers Island. Seems rough. But it was the statement that she was being held in lieu of $2 million bond that got me. She is a mother of four with deep connections to the United States. It is going to be hard to argue she is a major flight risk.

But somehow a $2 million bond (way more than most people could post) has been asked. This leads me to the eighth amendment:

Excessive bail shall not be required, nor excessive fines imposed, nor cruel and unusual punishments inflicted.

Somehow we have come to the conclusion that $2 million is not excessive bail. That I am puzzled by. When did America come to the conclusion that unless you were very rich you should be locked up pending trial for victimless crimes? What is it about the new American culture that does not think that $2 million bail is excessive?

Does anybody care or is Anna Gristina just another person arrested by police and hence guilty until proven innocent?

John

PS. If I had to guess the bail for a similar case in Australia - it would be bailed on her own surety (that is zero dollars). Australia's lack of a bill of rights looks pretty good here.

If you don't have enough cash you can't fix problems with your tool and you might lose all your properties

2012-03-08T15:50:00.003+11:00

Houston American is an oil-and-gas explorer which had enough cash for one speculative well in Columbia. Just one speculative well.

It had to work.

Alas recently their (down-hole) tool failed and their stock dropped 35 percent. The stock has since drooped a little more. But it was - as the CEO pointed out - a promising well. They had approximately 200 feet of "net resistive sands" which my readers helpfully point out means sandstone with low electrical conductivity and hence possibly saturated with hydrocarbons.

But they did not get to test those sands (yet) and tool failure meant they could not test the well at its target depth (and they had to plug the lower part of the well).

The question arises though - why didn't they fix the well? Why didn't they do what "big oil" does when it has problems (that is throw money at them). The answer is that they do not have much cash.

The 10K just came out. The first thing I looked at was cash balances. Unescrowed cash was 9.9 million compared to 26.6 million a year ago. At the end of September cash was 15.1 million. Most of the well expense has probably been incurred after year end and the cash balance is almost certainly low single digit million.

Which is not what you want when your tool breaks and it is going to cost a lot of money to fix it. Or even a fair whack of money to test the "net resistive sands".

Still the company is straight about it. The auditor did not give them a "going concern statement" which surprised me. But the company disclosed the problems anyway. Here is the disclosure from the 10K.

While our development costs were funded during 2011 with funds on hand and cash flow from our other producing properties, our funds on hand at December 31, 2011 and anticipated cash flow from operations in 2012 are not sufficient to fund our 2012 drilling budget. Accordingly, unless we are able to secure additional financing or substantially increase our operating cash flow, we may be required to curtail our drilling plans. We do not presently have any commitments to provide additional financing to support our 2012 drilling budget. If we are unable to secure additional financing, we may be unable to meet certain contractual commitments regarding the development of our properties and, as a result, may incur penalties or risk losing some or all of our interest in properties for which we fail to satisfy our funding commitments.

Bluntly if this company does not raise money it will not be able to meet its drilling commitments and may lose all of their interest in all their main properties.

Funny how they did not mention that when they talked about their "net resistive sands".

Lesson: if your tool fails, your stock droops and you have no cash you can lose all your properties. Even if you show some resistance.

John

Follow up to the small cap post - and some notes on SuperValu

2012-03-07T20:33:00.003+11:00

My blog post suggesting that small-cap stocks were mostly to be avoided roused the animosity of many readers. The problem was that many of my readers see themselves as value investors. A surprising number run small funds and my post was an attack on their world view.

Their logic is that it is impossible for a small fund manager to add value by analysing Hewlett Packard*, Vodafone*, Google* or Total* but by being small and diligent and nimble they can add value by picking small caps. They tell themselves (and possibly their clients) this story every day - it brings meaning to their life. They can add value. By saying just avoid small caps I was asserting that their rationalizations were bullsh-t. No wonder they bristled.

My restrictions were somewhat limited - I was only wanting to avoid buying small caps where the possibility of a go-private transaction was underpinning the price. In other words small caps in safe jurisdictions with good balance sheets and open registers were mostly to be avoided. Private equity mostly can not or will not buy financial institutions (with rare exceptions such as JCFlowers) - and there is some value in smaller financials. Likewise some companies that are already so levered that a debt-financed private equity bid is impossible are potentially interesting. Some German two-class-of-shares mid-caps are also interesting. But even these are at best partial exceptions to my rule of small caps being relatively expensive.

Still the rationalizations of the small cap value managers reminded of Woody Allen's zinger about rationalizations being more important than sex. "When was the last time you went 24 hours without a rationalization?"

Most of the comments posted wound up revolving around SuperValu - the grocer that owns Albertsons and others and which has been distressed and whose stock price reflects that distress.

One of my readers points out just how cheap it looks relative to potential. He figures the pain (and there has been considerable pain) is more or less over and the stock should race. Without a lot of work I can't even express an opinion on that.

But I will note that the first question when analysing a business is "what will they look like in three, five, ten years". Warren Buffett tells us that when he buys businesses he likes to look out decades. I am a little more flighty than that (and I can always dump the stock) so I tend to look 3-5 years out. Call it the "Wayne Gretzky school of value investing" - look at where the puck is going to be and ask if it is cheap against that.

And when you look out three to five years the biggest determinant of how they will look is what the competition will do to them.

Whatever: on this metric SuperValu is difficult. The grocery market is not growing much in aggregate in the US except through food inflation. And the competition at the bottom end is fierce. I would rather wrestle grizzly bears than compete head-to-head with Walmart. And at the top end the competition is also evil. (The Wholefoods store in Chicago where I irregularly shop is very nice. Certainly nicer than the average Albertsons.)

Sales are going backwards. That does not look like it is going to change - although plausibly the rate of decline may drop. This unquestionably a difficult story where a strained company is fighting with superior competitors. When small caps are cheap (and they do get there fairly regularly) there is no need to take on difficult stories. When to find value you need to go headlong into difficult stories then you are probably deluding yourself about there being value there in any general sense (although there may be value in specific instances).

The focus on SuperValu (a truly difficult story) was confirmatory of my view that on-average small caps are particularly difficult at the moment. [I should note however that SuperValu is something that would not appeal to most debt-funded private equity shops. The company is shockingly levered - and my general restriction against small-caps does not apply here.]

Metrics

I have a few metrics I think about with grocers. The main one is EV (meaning market cap plus debt) to sales. My rough rule of thumb is that an EV to sales of under 0.25 is outright cheap (and only seen either when the whole market is distressed or an individual company is distressed). You have to have a very high quality company to want to pay more than 0.5 times sales. These numbers have to be adjusted for retailers that own much of their property (Walmart, Tesco).

The logic is as follows: grocery retailing is a 5 percent margin business give or take a bit. $100 of sales at an EV to sales of 0.5 is $50 of EV. That $50 of EV would have $5 of operating profit associated with it (5 percent margin on $100 of sales). Now imagine the company had no debt and thus no interest bill. Take out tax at 30 percent and you have $3.50 in after tax earnings. That is for $50 of EV (which in this case is $50 in market cap). The price earnings ratio would be just over 16.6.

To pay more than 0.5 times sales you have to argue that unlevered this company is worth more than 17 times earnings. That is possible if there is a lot of growth potential or the margins are sustainably fat. But 0.5 times sales is a price above which I need to be finding rationalizations to maintain my interest.

When non-distressed grocers with solid market positions trade at 0.25 percent of sales (which is very rarely) they are half that price which is cheap by most measures.

Here is the last quarterly balance sheet for SVU:

	December 3, 2011				February 26, 2011
		(Unaudited)
ASSETS
Current assets
Cash and cash equivalents		$	196			$	172
Receivables, net			747				743
Inventories			2,616				2,270
Other current assets			226				235

Total current assets			3,785				3,420

Property, plant and equipment, net			6,226				6,604
Goodwill			1,306				1,984
Intangible assets, net			887				1,170
Other assets			581				580

Total assets		$	12,785			$	13,758


LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities
Accounts payable and accrued liabilities		$	2,720			$	2,661
Current maturities of long-term debt and capital lease obligations			396				403
Other current liabilities			643				722

Total current liabilities			3,759				3,786

Long-term debt and capital lease obligations			6,203				6,348
Other liabilities			2,078				2,284
Commitments and contingencies
Stockholders’ equity
Common stock, $1.00 par value: 400 shares authorized; 230 shares issued			230				230
Capital in excess of par value			2,860				2,855
Accumulated other comprehensive loss			(379	)			(446	)
Retained deficit			(1,450	)			(778	)
Treasury stock, at cost, 18 and 18 shares, respectively			(516	)			(521	)

Total stockholders’ equity			745				1,340

Total liabilities and stockholders’ equity		$	12,785			$	13,758

The last SuperValu balance sheet had $396 million of short term maturities and $6.2 billion in long term debt. There is a couple of hundred million in cash - which is such a minimal number I am going to ignore it. (There is 200 thousand dollars cash per store - a number that looks small relative to obvious cash needs including just balances in the till.)

$6.5 billion in debt give or take a little. The market cap is 1.35 billion according to Yahoo! EV is thus 7.8 billion. Last year sales were something like 37 billion (and on a very steep decline of about 10 percent per annum). This year they will be something like 35 billion. EV to sales is just over 0.2 - and will be probably close 0.25 when (and if) they can stabilize sales. This is the bottom end of my EV to sales range but is not an outright distress type figure. Given most this EV is debt I would not be much interested in the debt at par (even though it yields 8 percent). That seems like not much upside and in distress this retailer is going to be worth less than 0.25 times sales.

If perchance the debt were to trade at 70c - implying an EV to sales in the mid-teens - then I might get interested in the debt.

The equity is another issue - one I address below.

My second metric for retailers is how much of a lean they are taking on suppliers. Grocers sell stuff fast - many sell their stuff faster than they pay the suppliers meaning they get free funding from them. If they get into trouble (or they want the cheap finance) they let their supplier obligations blow out. I wrote a post once about an Australian wholesaler (Davids Holdings) which let its supplier obligations blow out and nearly went bust. Not nice.

A rough rule of thumb is as follows. Most suppliers give you 30 day terms. If your payables are more than 30 days of sales you are taking a lean on your suppliers. If you take too big a lean they start getting stroppy and ask for cash-on-delivery or letters of credit or the like. Too much of a lean is pretty tightly defined: most grocers have payables of about 35 days of sales.

In the above table payables are 2.7 billion. That is less than a month of sales - SuperValu is clean on this measure. However note that the accounts payable have gone up as sales have gone down. Whilst the level is not a sign of distress the direction is not good (the reduction of debt is not as impressive as it looks).

Finally - and this is the measure that most bugs me - inventory turn is falling. Inventory is up year on year. Sales are down. For a grocer this is unremittingly bad news. Not only are they using capital less efficiently (getting less aggregate margin per square foot for instance) but slowly and surely the store is turning into one of those places you shop only if you like your groceries pre-packaged and just a touch stale.

Whatever - on the numbers as given this is not that cheap relative to EV and the metrics are going the wrong direction.

You could add - and one of my readers did - that the company is underspending on stores. Tired old stores with slow inventory turns and stale product - that is not the way to take on Whole Foods. And unless you are going to shave margins to nothing it is hardly a way to take on Walmart.

If I had to make a bet on this my guess is that it will have to restructure in some form. This might be a sale (for debt reduction) of a large part of the business or it may be Chapter 11. Whatever - this is not easy and not an obvious value stock.

Would I short the stock?

There is a big short interest in the stock. I think the company is probably going to continue to have a rough time. I am a short seller. The obvious question is "would I short the stock?"

Here the answer is surprisingly no. The company in aggregate is not cheap (EV to sales is going to wind up somewhere near 25 percent) but the equity is cheap. Why? Well if things go right (and things always can go right) and the company gets say 100bps more margin - then the stock looks staggeringly cheap.

There are 35 billion in sales. 1 percent margin increase is 350 million per annum. That is very meaningful relative to a market cap of $1.3 billion. Add in a big short interest and the stock could be very strong.

The leverage that makes this whole thing problematic works both ways. If the management can right this ship the stock could be a big winner.

Have the management done a good job

My bullish commentator thinks the management have done a good job. As far as I can tell he is right. They have shrunk the business (a lot), paid off a lot of debt, and it appears been pretty straight-up-and-down about it. I am a little irked by the falling turnover (it will make the product stale) but that might just be the hand they were dealt.

I have not done a lot of work. I have not walked around these stores. I have not done any apple-freshness tests. But on the numbers I see no reason to believe management have not been pretty good.

That is a blessing and a curse. Good management will be necessary to salvage this situation. But if these stores have been well managed then getting a new broom in can't save the situation. You have to play the cards that are dealt.

Summary

If SuperValu is proof that there is value easily detectable in companies under $5 billion in market cap then - frankly - I think I will take my large caps.

I would not be long this without tangible on-the-ground evidence (from surveying up to 30 stores in different locations) that this really has turned around. Because at the moment this does not pass the Wayne Gretsky test of value. In five years it looks really really bad.

And I would not be short it either with that leverage without a decent understanding of their day-to-day liquidity and just how short-dated the situation is.

This one belongs in the too-hard basket. And half a day is wasted looking at another stock that ultimately I don't care about.

John

*For disclosure purposes we were once short Hewlett Packard but have covered, we are long Vodafone and Google - two of our biggest positions, and we were once long Total but have sold.

In praise of Frank Lowy

2012-03-05T15:10:00.001+11:00

Wayne Swan the Treasurer of Australia (in UK parlance the Chancellor of the Exchequer, in US parlance the Secretary of the Treasury) has been publicly criticizing the new Australian billionaires and their political influence warning that they are a risk to the Australian ethos of the "fair go".

He is quoted as follows:

"A handful of vested interests that have pocketed a disproportionate share of the nation's economic success now feel they have a right to shape Australia's future to satisfy their own self-interest."

Swan's critics have accused him of "class warfare".

This will be highly familiar to American readers who have got used to living in a world where lots of money gives you better access to speech. I have barely met an American who disagrees with this sentiment but mainly when the said pile of money disagrees with them.

To liberals in America the Koch brothers are evil incarnate.

Several conservatives think the same thing about Warren Buffett when he argues the rich should pay more tax. Governor Christie's comments were just plain angry. George Soros induces apoplexy in some conservatives.

And most Americans think there is something unseemly about K-Street and the influence peddling lobbyists of Capital Hill.

Money politics - American style - is settling in in Australia. Wayne Swan knows it.

But in Australia it is potentially much more dangerous than in America. Our new-era Australian billionaires - the ones Wayne Swan rails against - are all billionaires from resource extraction. They all get their money by digging up things that potentially belong to all Australians and selling them to foreigners. And they railed against the resource rent tax (a tax whereby the rest of us got paid something for their bounty). As well they might. And they rail against carbon trading schemes.

Indeed American style money politics in Australia is far more insidious than in the US because our billionaires are far less diverse. A diversity in billionaires (and in the way they make their money) gives us a diversity of billionaire opinion. You can get the Koch Brothers and George Soros in one system - and to some extent their opinions (and the money with which they foist them onto the rest of us) offset each other. The balance is preserved.

Here we risk no balance. And so I am writing a post to tell you just how important Frank Lowy has become. Frank is an opinionated billionaire who made his money from property management and shopping centres. He is "Mr Westfield". He is also highly opinionated and funds his own think-tank (the Lowy Institute). I have in the past disagreed with him strongly - but at the moment I am just darn pleased that he is there.

Lowy is fighting with Clive Palmer (a resources billionaire) about of all billionaire disputes - the business of owning football teams. But I hope that is just the start of it. He is our most opinionated non-resource billionaire, one with a global perspective - and suddenly he is part of the future of Australian democracy.

Frank Lowy (despite the high quality think-tank) has never shown the intellectual depth and breadth of vision of George Soros. I am just as familiar with his influence on local councils (getting his projects approved and his competitor projects rejected) than I am with his global vision. But Frank is all we have got. Billionaire visions are pretty thin around here.

I never thought I would say this. Frank Lowy - your country needs you.

John

PS. I am a hedge fund manager. My job is to find rich people, invest their money and make them richer. The rise of an Australian plutocracy is thus in my interests but I would prefer a plurality of plutocrat clients.

When your tool fails your stock drops 35 percent

2012-03-02T13:27:00.003+11:00

Houston American Energy yesterday announced a problematic exploration well. They had (drilling) tool failure. The stock fell 35 percent.

I read a lot of press releases: this one is amusing.

HOUSTON, March 1, 2012 /PRNewswire/ -- As reported in Houston American Energy Corp's (NYSE Amex: HUSA) Quarterly Report on Form 10-Q for the quarter ended September 30, 2011 and in Form 8-K on December 19, 2011, drilling operations on the Company's first well on the CPO-4 block in Colombia, the Tamandua #1, with a projected target depth of 16,300 feet, commenced in July 2011 and was subsequently sidetracked to address drilling issues associated with high pressure and inflows of hydrocarbons and fluids into the well bore. As of December 19, 2011, the sidetrack well had been drilled to 13,989 feet and efforts were ongoing to control the well bore while continuing drilling to the target depth.

Subsequently, and as of March 1, 2012, the Tamandua #1 sidetrack well had a 7 inch liner run to 13,913 feet and was drilled to total depth ("TD") at 15,562 feet. Upon drilling the well to TD, the well encountered Paleozoics which was a clear indication that the TD had been reached.

While the well exhibited oil shows while drilling, and other indications of hydrocarbons such as log analysis that indicate possible productive sands, hole conditions have prohibited sufficient testing on the bottom hole sections. There have been many attempts to evaluate the well resulting in tool failures and stuck pipe, and current conditions are such that the operator has made the decision not to try to reenter the bottom hole sections. As a result of these developments, the decision has been made that without the ability to effectively test the lower zones, the most prudent course of action is to plug back the well and to further evaluate the C-7 and C-9 Formations. As previously reported and indicated by the Logging While Drilling data, the well encountered approximately 200 feet of net resistive sands in the C-7 formation and approximately 140 feet of net resistive sands in the C-9 formation (resistive sands do not necessarily mean pay).

Results of the further evaluation of the C-7 and C-9 formations will be announced as soon as they are available. After attempting to complete the well, the rig is expected to be moved to one of two locations that are currently permitted and ready to receive the rig. In addition, the Operator has five additional locations that are in various stages of permitting, location and construction.

John

And a follow up question: can anyone explain to me what is meant by "net resistive sands"? The phrase does not appear anywhere in the Google database not linked to this company.

Post script: There is a Bloomberg article which quotes the CEO as follows:

“I would like to make it clear to our investors that the Tamandua #1 well is not being abandoned,” John F. Terwilliger, chief executive officer of Houston American, said in an e-mailed statement today.

“Current ongoing operations are to make a completion attempt in the C-9 and C-7 sands,” he said. “As previously reported, the Tamandua #1 well exhibited hydrocarbon shows in the C-7 and C-9 sands, and logged approximately 200 feet of net resistive sands in the C-7 formation and approximately 140 feet of net resistive sands in the C-9 formation. We are eagerly awaiting the results from these completion attempts.”

This corrects a previous article which unambiguously suggested the well was dry.