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:
- 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;
- CEO and founder suddenly leaves and cashes out a large portion of his wealth. Always a flag.;
- 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.
- 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.
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.
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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.
Great to get some insight into how these attacks play out (on both sides). Question: Why doesn't the attacked company seek a second and third opinion on the veracity and strength of their contentions behind the values of 'internally assessed' asset values? Presuming they are positive, they then use these to publicly discredit Glaucus. Personally, I am secretly hoping there is somone out there who can put Glaucus on the canvas.
Thanks so much for those insights Chad. I had my finger on the buy button but not now, I will wait till things settle and become clearer.
Chad, great piece. Interested if you had thoughts around the insider selling in BLA?
Well written Chad!
Nice read. It is hard to know who to believe until the assets are tested for value, either sold or independent valuations obtained. If BLA is confident selling one key asset at or above the carrying value would probably be enough to scare the "short" out of Glaucus along with giving others of a similar mind pause for thought.
chad, as always it's kinda interesting reading your article, and then reflecting for example on the article titled "strapped for cash: property payouts rise faster than earnings" by nick lenaghan in the afr on 24/3/18. Internal valuations, divvie>FCF, mgt alignment etc anyone? [certainly not suggesting fraud etc, just reader caution in these sort of stocks at this stage of the cycle] Along with the swag of new, untested "high conviction" or "Long short" etc cashbox/LIC raisings as smart managers lock in funds that can't be withdrawn by investors, there certainly does seem to be a decent dose of very late cycle behaviours going on - with all the same risks as prior cycles, just dressed in ever-so-slightly different clothes!
The thing with BLA is that its business is to invest other people's money and so it relies heavily on its reputation and investors' confidence and trust. This episode may be a mortal blow to investor confidence and trust in BLA even if the Glaucus claims prove to be exaggerated.
Enjoy reading your insights, Chad. BLA business relies on trust, whichever way it turns out its going to affect the growth and amount of fund that will be put under their management. Will take long time to recover in my opinion.
You're not so unsharp yourself Chad. Seriously, always worth reading. As a fundamental guy I am as often surprised at the stuff that goes unmentioned as the stuff that is. I totally appreciate the focus of the artIcle, that being asset valuation. However, given the lack of transparency in that department, how about turning to earnings? In BLA's case, the recent disconnect between price and earnings has been glaring. In January the share price was $14.60; a market cap of over $1B. FY2017 earnings of $20M. Trailing PE of >50x. 1H2018 underlying earnings of $16.1M (statutory result was half that). Where is that headed for the year? $30-35M. A bit hopeful I think. So we're still talking a forward PE of 12-15x on current market cap of $435M. The short makes sense from that perspective alone. Earnings trajectory plainly not supportive of recent market price. Although, might be getting close now.
Thanks for all the comments, quite a few here so will try and address them. Firstly to Damien Parker: Whilst it is logical what you propose, if I was short I would point out this is like a defendant getting to chose their own Judge! The same applies if Glaucus got to chose the valuer. The only "clean" outcome is someone fronts up with cold hard cash for an asset. End of dispute for that asset. Now lets also be clear - this is a risky strategy, because if they don't get bids near their marks, the auditors will not let them leave the old marks, as the auditors are then open to being sued. I'm not saying these are easy choices to make - just pros and cons to each option. Doing nothing is also not risk free (redemption risks or being bid for at a cheaper price than you think the business is worth, etc). But that's why Board of Directors get paid -for times like this to earn their money.
To Wentworth Securities: Hadn't added that to the list of flags, but it never looks good. That said, senior managers do have needs outside of work and the stock was deep in the money for lots of them. Could be unlucky timing, just adds to the list unfortunately.
ALAN CTHGPRO: Agree. Surely in the many assets there are some where they are sufficiently advanced. Or even better - sell some of the disputed assets. They may take small negative marks, but it's small beer compared the decline in their market cap.
George & Trevor: Trust is why I raised the Babcock and Macquarie examples, as all Financial services are trust related. After all, the industry doesn't produce anything "material" the way a factory does. I don't think it's a lost cause for trust, just a long journey back. But in the long history of companies, 2-3 years isn't that long. And I'd argue if they pass through this, as we've seen with Macquarie, the issues are buried.
Ron: Yes, the article was already getting to 1200 words without a valuation discussion! From a shorting perspective, a stock Being overvalued doesn't mean it's a good short, it does though mean if something goes wrong, the outcome will be skewed in your favour as the distance to fall is larger than usual. Clearly valuation in both earnings and Percentage of FUM was on the high side going into this episode which is exacerbating things on the downside.
Good thoughts Chad except there is far more to the Blue Sky obfuscation than some questionable asset values and a clear interlink with opaque fum/aum and non granularity of management fees. A further obvious point is that the level of analysis of a $1bn+ company by the local market was appalling. Only short sellers (domestic or offshore) seemed to understand how the company was operating. There is a good analogy with B&B - rather less so with Herbalife which as you know mints cash flow and has been a capital management machine.
Good piece Chad. I have always thought it curious that companies never mind when bullish analysis (sometimes well wide of the mark in hindsight - BIG etc) are issued to the market, particularly when the broker may have a relationship with the company, but suddenly get upset when someone issues a negative piece. When a short target goes running to the regulator for protection rather than articulate their business I think that's a red flag for mine.
Very well written and balanced piece Chad. Given you are a long-short investor, you are uniquely placed to present the perspectives of both long and short investors. You have also provided some instructive guidance to the corporates on: 1. How to avoid short-side attention in the first place 2. How to prepare in advance for a potential shorting attack and 3. How to actually respond when the short trade goes live.