QXM and XING

Ugh.  These are Chinese reverse merger stocks.  (A reverse merger is a ‘bootleg’ method for companies to quickly get listed on US exchanges.  For whatever reason, most reverse merger stocks are frauds.  I haven’t seen any insiders get thrown into jail due to the complications of international law.  Regulators and exchanges shouldn’t allow this… but they do.)

The history is that originally XING IPOed an interest in its cell phone business in an IPO (which is QXM).  Later on, the stock price of QXM tanked and there was a lawsuit over the accounting practices at QXM (the financials had to be restated to show that QXM was not profitable in its early years).  Oh yeah… insiders steal from this company… read the related party transactions.  When XING was trading below the value of its ownership stake in QXM, insiders decided to merge XING with a mining company owned by the chairman.  Now if you read the financials carefully… you’ll notice that they capitalize the stripping costs of the mining operation.  This is rather inappropriate as stripping costs should be expensed; capitalizing them inflates earnings and EBITDA in the short term.  Management points out the EBITDA figure when XING bought the mine… but EBITDA is a terrible method for valuing any mining asset.  The most appropriate method would be Net Present Value (though it is easy to fudge NPV values).  Projections of expected production, grades, and free cash flow over the expected mine life would also be appropriate (though few people ask for these figures).

Riu Lin Wu and Real Gold (HKG:0246)

Riu Lin Wu is the former chariman of XING (he has now been replaced by his eldest son).  Real Gold is another Riu Lin Wu-related entity (Riu Lin Wu is the majority shareholder and pretty much controls the company).  There is a huge ongoing scandal with Real Gold because it has been secretly lending money to Riu Lin Wu’s companies.  The interest rates that it has been charging were presumably insufficient to compensate for the credit risk involved.  The auditors at Real Gold have resigned.

Now back to QXM and XING.  QXM is a cash rich company… so why do its financials show that it is borrowing money?  To be fair, there might not be anything shady in this department.  But I am a paranoid kind of person.

There are a lot of shenanigans going on with the various convertible debentures at XING and QXM.  The related party ones have been terrible deals for XING/QXM shareholders.

The underlying business

Unlike other Chinese reverse mergers, I believe that there is a real company here.  (Though I can definitely be wrong.)

VEVA makes high end cell phones.  There are user reviews of their cell phones on the Internet.  Here is one of their infomercials:

The infomercials are pretty slick actually.  The one above features Pace Wu (Pace who?), who is apparently a minor star in China (read the Wikipedia entry for her).  Veva has also hired Zhang Ziyi, who is definitely a star inside and outside of China.

QXCH (owned by XING, not QXM) makes indoor phones.  It has been losing money (or “losing” money) and has been sold.

Why I am long QXM and XING, not short

My original thesis was that insiders would try to pump and dump these stocks onto institutional investors, similar to how QXM was originally IPOed.  It seemed to make sense at the time because insiders sold the mine to XING for shares, not cash.  XING was also going to perform a take-under (or fake takeover?) of QXM, but this proposed transaction failed.  Unfortunately, insiders have not been trying to pump and dump these companies and the stock prices of both have fallen by about three quarters.  The websites for both companies are badly outdated and there has been little communication with shareholders.

Shah Capital Management is a major shareholder of both companies and has not been pleased with management (read their unhappy letter to the QXM board).

I have been in a world of pain because of these two stocks.

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Marriot Vacations (VAC)

Some very quick observations… it looks like the main goals in the spinoff were:

1. Financial engineering to boost profits.  By adding leverage to the spinoff company, the debtholders (ok, they actually own preferred shares) shoulder taxes that the shareholders would otherwise have to pay.  There is a tax arbitrage here in that the debtholders probably have preferential tax treatment compared to the shareholders.
2. The parent company wanted to get rid of a company that may have negative growth and/or lumpy earnings.  This allows them to make their company easier to understand and hopefully it will attract a better share price (buyers tend to pay more for situations that are easy to understand and have steady profits).

So if you look at the spinoff carefully, the spinoff has issued preferred shares with a ludicrously high interest rate.  This, in a way, overstates book value at the spinoff.  The spinoff is also obligated to pay royalty payments to the parent… I am guessing that this liability is recorded with a book value of 0.  Again, book value of the spinoff is overstated.

Economically, leveraging the spinoff isn’t necessarily the greatest move since the timeshare business may get killed in a recession and the debt levels may become dangerous.  On the other hand, it could very well be a safe level of leverage.

I like to see spinoff situations where management is actively trying to get investors to sell the spinoff too cheap.  This can create the potential for some very nice gains and I think it will happen to MFC Industial Ltd (NYSE:MIL).  However in the case of Marriot Vacations, management is trying to dump the toxic waste into the spinoff much like the Seahawk/Pride spinoff (Seahawk is now in bankruptcy… though this has a lot to do with the Deepwater Horizon disaster, low natural gas prices, and the low cost of shale gas compared to offshore gas).

Disclosure: I used to own Marriot pre-distribution and sold after the spinoff.  I own neither the parent nor the spinoff.

Fortuna Mining

Let’s take a look at their latest MD&A:

I call bullshit.  If you look at the breakdown above, you can see that management expects a ramp in Tonnes milled and a ramp in Au and Ag grades.  Sane mine engineers do not make plans like this.  First off, it is optimal to mine the highest grade ores first to maximize the net present value (NPV) of the mine.  In some mines lower grade ore has to be mined first to get to the highest grade ore.  But generally speaking, you should pretty much see the highest grade ore get mined first.  Mining the highest grade ore 2 years before mine closure makes absolutely no sense at all.

Secondly, the breakdown above calls for production to ramp up to more than four times over four years.  This is a dopey way of building a mine.  It makes more sense to build to a specific capacity by year 1/2 of commercial production as this would maximize the NPV.

What’s probably happening here is that management is making stuff up.  It is highly, highly likely that grades will go down over time according to the mine engineer’s plans.  And my personal opinion is that this company will likely miss its production targets and that this will be blamed on external factors.

Is it any wonder that commodity futures outperform commodity-producing companies by three times?

Contango Oil and Gas (MCF)

History

The CEO, Ken Peak, took his life savings of $400k and started the company, which was traded on the OTCBB.

One of the original strategies was to focus on oil and gas exploration as it is an area where a lot of value can be created.  Exploration skill tends to follow an uneven distribution where a minority of people will account for almost all of the oil and gas discovered.  (Much like the 80/20 rule, how sports superstars command most of the pay, how superstar actors make almost all the money, etc. etc.)  I believe the explorationists came from Xilka Energy, which had a very good exploration track record.

When Contango started out, it couldn’t afford to drill the wells itself.  Its business model hinged on generating good exploration ideas and then convincing other people that they are good ideas.  Other companies would drill the well and give Contango a cut of the profits.

Over time, Contango has been selling its prospect generation business to the explorationists who run it.  Remember that the explorationists can simply walk away and restart the business with their own capital.  The current situation is that Juneau Exploration (“JEX”) is pretty much owned by its explorationists and acts as Contango’s partner.  JEX generates ideas for Contango and Contango pays for much of the drilling costs (they don’t farm a lot out anymore as Contango is a much bigger company).

Venture Capital

This was Contango’s other big idea when Contango first started out.  Unfortunately it did not work out so well and Contango only recovered about half of its capital.

Alta Resources / Unconventional gas

Contango entered into a joint venture with Alta Resources, which did research into extracting natural gas from shale.  Once they started understanding the process, they knew what types of shale/land are good for shale gas production.  The joint venture bought a lot of land rights before other people really knew its value for shale gas.  Ultimately the joint venture hired investment bankers to help flip all the properties to other companies.

Nowadays Ken Peak isn’t that keen on shale gas.  While wells do vary in production, there isn’t a lot of exploration risk when many wells are drilled.  And it doesn’t take a lot of capital to drill a lot of wells compared to drilling in the Gulf of Mexico.  Ken Peak characterizes shale gas as ‘factory’ production.  As the process is more understood now, there isn’t a lot of room for value creation (this is why Ken Peak notes that landowners are getting much smarter now).  He is also worried about the environmental movement, as developing shale gas involves injecting fracturing fluids into the ground with the potential of contaminating groundwater aquifers.  Companies do not currently have to disclose the composition of fracturing fluids(!).  There may be regulations in the future and/or NIMBY protests that will lower profits for shale gas companies.

Contango’s current partnership with Alta Resources is to look at extracting shale gas from offshore reserves.  This is partially a speculative bet on much higher natural gas prices in the future.  With natural gas prices so low right now, a lot of onshore shale gas is not economic.  There is potential opportunity as landowners may not realize the value of offshore shale rights, which seem pretty worthless right now.

Liquid natural gas imports

Back in the day, it was thought that the US would have to import natural gas to meet its energy needs.  Contango made a private investment in Cheniere Energy (symbol LNG) when its stock price was extremely depressed and things look bleak for the company in getting a LNG facility fully permitted and built (a de-gasification facility can only import liquid natural gas, not export it).  Cheniere actually managed to pull it off.  Unfortunately, the industry started to figure out shale gas technology and the US was flooded with cheap natural gas.  Contango is very fortunate is having sold its investment in time, as it looks like the US should be exporting natural gas rather than importing it.  Cheniere is in the process of trying to convert its facility to export LNG (they might succeed).

Hedging

Ken Peak used to be a proponent of hedging.  The problem with fluctuating natural gas prices is that losing money can seriously affect the rate of return.  If the company were to lose half its value, it would have to double its value just to break even.  And if the company has a small chance of going to 0, then it eventually will go to 0.  This is also why Ken Peak does not like leverage, as he has seen too many E&P companies go bankrupt throughout his investment banking career. 

By hedging its output, Contango is able to avoid huge drawdowns in its value.  It does give away some upside but over time the rate of return is arguably superior.  Ken Peak is also well aware that it is dangerous to short futures (and to take short positions via swaps).  If there is a hurricane, Contango may be forced to shut production.  Lower production across producers will raise natural gas prices.  Contango would have zero production while it is obligated to deliver natural gas, which is now at very high prices!  This is why Contango bought call options to protect itself from its swap positions / natural gas shorts.  The overall position is very similar to buying put options and being long volatility*.

(*On the other hand, it may not be a perfect hedge as one set of risks was traded for another.  There are likely differences in delivery location, sulfur content/penalties, mix of natural gas liquids in the natural gas, etc.  Buying put options outright has fewer of these risks… though there may be a spread in price between delivery locations.)

Contango currently does not hedge.  And it probably will not hedge unless gas prices are much higher and volatility is cheap.

Contango’s current strategy (as I understand it)

Other than the onshare shale partnership, Contango is going to stick to its bread and butter: wildcat exploration.  In the wake of the Deepwater Horizon accident, there has been significantly less drilling activity in the Gulf of Mexico because it is harder to get permits, the environmental liabilities are higher, and because gas prices have stayed stubbornly low (most companies cannot economically drill).  Ken Peak is incredibly excited about the GOM as drilling costs have come down significantly and the economics for Contango are extremely attractive.  It has always been able to find gas cheaply and should be able to continue to do so.

In an ideal world, he would probably sell all of Contango’s producing assets and invest it all into wildcat drilling.  Contango should be able to achieve a higher rate of return on wildcat drilling than sitting on its developed assets.  Presumably there are reasons why this hasn’t happened (presumably the private market for gas assets is not very good right now with stubbornly low gas prices).

Contango seems to be having a lot of delays in getting its drilling permit as they were supposed to spud one of their prospects in Sept/October and they still haven’t done so.  In the meantime, they are buying back shares.  Contango should be able to acquire natural gas (or oil) assets cheaper by drilling than through share repurchases.  Its rate of return is being hampered by its inability to drill drill drill.

Outlook

I’m pretty bullish about natural gas.  The current prices are unsustainable as few sources of natural gas are economic at these levels.  Also, Fukushima was a very good thing for natural gas as power generation will shift away from nuclear.  China is starting to recognize its pollution problems and this should reduce its reliance on coal.  This points towards natural gas as being the fuel of choice for baseload power generation.

What I’m actually doing

Trading in and out of Contango.  I recently sold all my shares and am trying to buy them back at $59.  Is this a great idea compared to buy and hold?  Maybe not.

My quick take on PRXI (Premier Exhibitions)

I just don’t think it’s deeply undervalued.  (VIC writeups here and here.)

1- In theory, its Titanic assets are worth a lot.  However, you should read the court filings for yourself.  If Premier Exhibitions wants to sell the Titanic artifacts, it has to sell all of them together.  It cannot sell them separately.  This will make them difficult to sell.  On top of that, Premier will want to lease/rent back the artifacts that it is using for its successful Titanic exhibition.

Premier for a long time has been trying to get permission to sell the artifacts piece by piece.  The judge is NOT happy with them for trying to do this.  I suspect that the judge’s emotions will rule the day and Premier will not get what it wants.

From the buyer’s point of view, the demand may be questionable.  You have to pay ~$200M to buy the artifacts and you are obligated to maintain them (if you cannot maintain the artifacts, you will not be allowed to buy them).  And what is their utility?  I only see somebody buying them for the same reason they buy a piece of artwork.  However, to exhibit these artifacts in your house… you will have to rotate the artifacts in/out to prevent damage associated with exhibiting them (as is the case with the Titanic exhibit).  Is there a market for this?  Maybe.  But figuring out the market for this asset is too hard for me.

2- Management: The old management was very good at running an exhibitions… the new one not so much.  That is why Premier will not be able to maintain its historically high returns on equity.  This is a business where Premier doesn’t have any special advantage or economic moat.

Sanofi / Genzyme Contingent Value Rights (GCVRZ)

See a different writeup on GCVRZ here for some background: http://www.valueinvestorsclub.com/value2/Idea/ViewIdea/53388

In my opinion, they are only slightly undervalued (maybe 20-30% at $1.03/CVR) and here’s why.

Drug potential

Now that the first set of phase III trial results are in, it seems that:

PRO

Efficacy better than the traditional CRABs/ABCRs for relapses. (The phase III trial only compared efficacy to Rebif.  But it is likely that doctors and patients will extrapolate.)

?Efficacy only slightly better in terms of disability.  However, the phase III results weren’t great as this was not statistically significant.

Arguably more convenient that most other treatments on the market.  You have to sit in a hospital for 5 days while on all sorts of drugs (with a small chance of being well enough during the infusions to be able to go home).  This may not be so bad compared to constant injections with Rebif, monthly injections with Tysabri, etc.

CON

One person died during phase II trials from ITP.  This will be a huge cloud over this drug.

Major side effects… a chance of developing thyroid problems / Grave’s disease (treatable) and a heightened chance of developing ITP.  While ITP is treatable in theory, its mortality rate is not zero (e.g. as demonstrated in the phase II trials).

—

So here’s my quick analysis of the drug.  Its efficacy and mortality rate is similar to that of Tysabri.  In the initial phases, I feel that doctors and patients will rate Tysabri as safer because it has been around longer and therefore the long-term effects are better understood.  Over time, the tide will likely shift the other way as ITP is better understood than dying from PML with Tysabri (there is no cure for PML…).  So I make the simplifying assumption that Lemtrada will perform similar to Tysabri.

Tysabri is on track to doing about $1.3billion/year sales 7 years after its FDA approval.  If Lemtrada performs similarly to Tysabri, then it has a chance of hitting the $3 sales milestone of >$1.8billion sales after you figure in inflation.  It has an EXTREMELY low chance of hitting the $2 sales milestone of $400million sales during the launch year(s).  Tysabri never had sales that were that strong during its launch phase (and was even pulled off the market due to safety concerns over PML).  Sanofi may also have an incentive to sabotage/defer/stop sales during this initial period to avoid paying the $2/CVR.

Of course, it is likely that Lemtrada and Tysabri will split some of its market share as they are similar in risk/benefit.  So I wouldn’t count on the $3 milestone as being a sure thing.

Another way of looking at it is to realize that the payouts are rather lofty goals in the context of the drug industry.  A blockbuster drug is defined as one that makes $1billion/yr in sales.  Tysabri took several years to reach that point.  And the drug industry is having a very difficult time cranking out blockbuster drugs.

Bottom Line

At this point, I would say that analyzing future sales of Lemtrada is very hard.  I’m not that smart.  But I don’t see a margin of safety here.  FDA approval at 90% probability gives almost 90 cents of value.  The $3 sales milestone will take several years to materialize and its present value is worth tens of cents depending on what probability and discount rate you use.  But how much do I really know about pharmaceuticals?  In my opinion, these rights are easier to evaluate than a pharmaceutical company.  This market doesn’t look that inefficient.

Other factors

– Devaluation of the US dollar is slightly favorable for CVR holders.  Of course, this is a two steps forwards one step back kind of thing.  While the higher payoffs are easy to trigger, you will receive US dollars that aren’t worth a lot.

– Lemtrada is not cheap.  Some think that the treatment will be $60k.  Most people simply cannot afford this without health insurance.  Future changes to the health insurance industry may help or hurt sales of Lemtrada.  I don’t understand the industry well enough to know what will happen.

– I could be understating the potential of Lemtrada???  Maybe it is God’s gift to MS sufferers that cures the disease and reverses its effects, as Genzyme’s pre-marketing efforts would like you to believe.

– To be fair, a comparison to Tysabri may not be a great idea as doctors have to weed out patients who are susceptible to PML.  As well, you can only get Tysabri from a doctor who are part of its restricted distribution program (again, so people won’t die from PML).

– Sanofi is allowed to repurchase these rights.  After 2014, it can force all rights holders to sell their rights if they under $0.45 for a period of time.  This could be unfairly used against rights holders???

– Tax treatment is uncertain.