Some Thoughts on the Blue Sky Affair from a manager who shorts

Chad Slater

Ellerston Capital

By now most of the Livewire readers will be aware of the battle between Blue Sky (BLA) and the US short seller, Glaucus. I thought it may be worth penning a wire as I sit at the junction of the two: I know either personally or indirectly several the team at Blue Sky, but I also run a fund that short sells stocks. Lastly, I have been long a stock when it came under heavy short attack for its business practices (Herbalife). Whilst we don’t operate to the Glaucus method of shorting, we nonetheless do publish our short thesis in public often, as evidenced by our Platinum short from a few years ago. And to be clear from the outset: we have no position in BLA stock.

Background on BLA and short attacks

It doesn’t actually come as surprise to me that BLA has been singled out as a short. I have been contacted on a number of occasions over the last two years as to my thoughts on BLA’s business model from a short sellers perspective. Many of the issues raised by Glaucus were raised in those phone calls as a concern previously:

  1. A business with internally valued assets. Businesses with assets that are “marked to market” by company paid affiliates (auditors etc) are vulnerable to manipulation as the incentives are there for management in bonus payments, to hire someone to tell them what they want to hear Now clearly not all companies will do this, but it is a murky area. Definitely a flag;
  2. CEO and founder suddenly leaves and cashes out a large portion of his wealth. Always a flag.;
  3. A very young senior team, that has a background in Management consulting rather than industry. Management consulting attracts some of the best and brightest graduates (my friend who hired Rob Shand to Bain described him as one of the sharpest she’s ever recruited and she’s one of the sharpest I know!). Unfortunately sometimes these brains can be put to more nefarious uses: Enron and Jeff Skilling, came from McKinsey & Co.  Enron also had “mark to make believe” issues.
  4. Grown very rapidly from a small base. Another flag.

In that respect, it should come as no surprise to the BLA senior management team that this short story has emerged – if people have called me with issues, they surely knew. What is a surprise is that they seemed to have no “war plan” so to speak, ready to go for this. Or if there was a war plan, it doesn’t seem well thought out.

Unfortunately I’d say their defence up to now has been below par. The journalist, James Thomson at the AFR hit on this yesterday and again today in his articles. Their appeal to ASIC, litigation and continuous reference to Glaucus as being just opinions really missed the point. All short targets run this line of defence. Click on this link to read about how Noble Group, a commodities trading house Singapore respond to the shorts in 2015. Quoting from the Business Times article:

Its financial results are reported in line with the International Financial Reporting Standards, and have been audited by Ernst and Young with unqualified opinions, the commodity trader said in a statement on the Singapore Exchange after trading hours.

"The carrying values of our associates, including Yancoal, are tested for impairment using discounted cash flow models that are updated every quarter," Noble said.

Iceberg Research, a little-known research firm, had on Sunday published a report that questioned Noble's treatment of certain companies as associates, and said that it "grossly overstated" the value of these companies.

Look familiar? Reputable auditor with unqualified accounts. Noble Group was $8.50 then. Today? It’s 6c.

                  NOBLE GROUP SHARE PRICE 2015-2018

The problem for investors is both frauds and real businesses give the same answer. Investors can’t know the difference. So they just sell. It’s a rational course of action, even it seems irrational to the BLA team.

Suggested next steps for BLA

Firstly the bad news for management and shareholders: this isn’t going away for probably two to three YEARS. If we look at Herbalife as a case study, the Einhorn short issues of 2012 and then the Ackman attack of 2013 drove it from $75 to $25 over 12 months. Short Interest surged over those 12 months to 40% of the free float. Now, 6 years later it is returning to normal as the stock makes new highs towards $100. But it’s a long journey.

                  HERBALIFE SHORT INTEREST 2011-2018

BLA management might say this is unfair and is a distraction from their business. My reply is that being a public company enables one to essentially become a central bank: cash can be created by issuing shares. This is a privilege and with that comes a much higher level of scrutiny and inherent debate compared to the private market. Often that debate is with pesky long shareholders who become activists when they don’t like the direction of the business. Shorters are just another type of engagement one must deal with in the capitalist ecosystem.

I also have little sympathy for the argument that since Glaucus is an opinion piece only it should be disregarded. Nearly all investment analysis is an opinion to a varying degree. I often say to our analysts we are not in the business of news reporting (“Company X sold less widgets this quarter)”, we are in the business of opinion columns (“it’s really bad they sold less widgets because this implies end demand is collapsing)”.

Would BLA seriously have us believe that if Glaucus had rang them up in advance BLA would have opened their books for them? I doubt it. So of course they have to operate without management interaction. As a short seller I am nearly always forced to operate without management interaction.

Resolving the debate

Finally, my suggested solution to help resolve this more swiftly than three years. The core issue being debated is that the assets on the books of BLA are not worth what BLA say they are. BLA can resolve this quite simply: over the next year or so, monetise assets by selling them at or near what they are marked in their books. At that point there is little room for debate. Sure Glaucus can argue here and there about them only selling the good ones, but if one by one assets are sold at the values BLA has, a short squeeze will ensue over time.

If I look at Kerr Neilson at Platinum and the team at Herbalife, they suggest the most rewarding way forward: focus on running the business and over time the shorting issues will resolve themselves. BLA just raised capital, so they shouldn’t need new capital.

Markets are not totally irrational – there was a lot of money to be made from Herbalife if one was certain the Ackman accusations were wrong – and likewise buyers should emerge for BLA as it becomes clear they have not got false marks against their portfolio.

Conclusion

In the 2000’s there were two hot, fast growing, innovative financial stocks. Both were run by young, aggressive and smart staff. One was Macquarie Bank. Jim Chanos attacked it as “ponzi scheme” in 2007. The lines of attack were similar to now. It turned out Macquarie Bank was not a ponzi scheme (though how much the Australian government bailout helped, we will never know). It is now valued at $35bn and a global leader in investment banking.

The other was Babcock and Brown. Some younger readers may not even know it, but at it’s peak it was a $9bn company. It was in administration by 2009.

Whilst it may be cold comfort to the team at BLA, it would seem this is a rite of passage they need to make if they are to realise their ambition to become the KKR or Blackstone of Australia.

About Morphic

We’re globally responsible investors that can profit from both long and short positions. We have the ability to move fast to protect capital in market downturns. Find out more


Chad Slater
Co Head Global Equities (ex-Asia)
Ellerston Capital

Chad co-founded Morphic Asset Management in 2012. As a stock picker Chad is also a generalist but has strong regional knowledge of Europe and the Americas. He has also been awarded the CFA Charter.

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