Lawyers Behaving Badly

Q: What’s the difference between a catfish and a lawyer?

A: One is a scum-sucking bottom feeder and the other is a fish.

I have recently made the acquaintance of a law firm that appears to use the above joke as its guiding principle. That firm is Friedman & Wexler. I recently got a new cell phone number and it just so happens to be the old phone number of someone who didn’t pay her bills. Friedman & Wexler has been playing the part of the collection agency and has been harassing me with automated phone calls to try to get me (actually, the former user of the phone number, Jasmin) to pay them. I sent them an email and asked them to stop harassing me and yet they keep calling me. Unlike with real collection agencies, no one comes on the phone if I pick up; the message simply says to call them. I am not about to waste my precious time trying to reach someone there and tell them that my name is not Jasmin and that I don’t owe their client money, so I’ll just ignore their calls for the next month and then I will get a new phone number with my shiny new 3G iPhone.

Ener1: Stock Dilution is Not the Solution to Pollution

The Company

Ener1 [[hev]] is in the exciting business of developing safer and more powerful lithium-ion batteries for use in hybrid gas-electric cars and in other applications. This is a laudable goal. From a business standpoint, however, there is a lot of risk. There are a number of other companies pursuing similar products at various stages of research, development, and production. A123 Systems is a private company that is already supplying Black & Decker with batteries for portable power tools as well as supplying test batteries to GM for possible use in the Chevy Volt. The MIT Technology Review has a positive article about A123 in the May/June 2008 issue. One public competitor, Altair Nanotechnologies [[alti]] has not produced much and has become a target of short sellers.

Ener1 does not yet have any products on the market; it is currently only at the working prototype stage (and that prototype has been independently tested and verified). I am not an expert on batteries so I cannot comment on how Ener1’s prototype compares to Altair’s prototype and to A123’s production batteries and prototypes. I can point out the financial difficulties that Ener1 will face, though. Stated in its recent prospectus is the stark fact that the company “will need additional capital to fund development and production activities.”

Contracts

Ener1 has a supply contract with Think Global to supply it with batteries for its electric vehicles. This contract, however, requires Ener1 to provide satisfactory batteries meeting the specifications of Think Global. Ener1 has yet to meet that requirement. Also, even if everything goes according to plan, this will only result in $70 million in sales for Ener1 through 2010. Here is the company’s description of the contract from its most recent 10K:

On October 15, 2007 we entered into a two year Supply Agreement with Think Global of Oslo, Norway, (“Think”) to supply Li-ion battery packs for the Think electric vehicle, Think City. Under the Agreement, EnerDel must deliver production prototypes in March 2008 and pre-production parts in July 2008 in exchange for approximately $1.4 million. After completion of the production prototypes and delivery of pre-production parts, if Think’s design and test requirements have been met, Think will order battery packs on a rolling six-month purchase order. If these requirements are met, the first order is expected to be placed in July 2008 with the first delivery expected by the end of 2008. We estimate orders of approximately $70 million based upon Think’s minimum forecasted vehicle delivery schedule for 2009 and 2010, although quantities may increase from the estimate. Think may increase the number of units on six months notice. Think is not obligated to buy any units if design and test requirements are not met.

Valuation

After a recent 1 for 7 reverse split effected on April 24, Ener1 has 98.81 million shares outstanding. At a recent price of $6.49 per share, this gives Ener1 a market capitalization of $641 million.

As of the year ended 2007 (see the 10k), Ener1 had cash of $24.8 million, total assets of $31.3 million, and about $12 million in liabilities (after accounting for the company calling its Senior Secured Convertible Debentures and extinguishing the related liability on the balance sheet). The company has a book value of $19 million and it has lost a total of $241 million over its lifetime. With negative free cash flow of $27 million in 2007, Ener1 will almost certainly have to raise more money before the end of 2008 if it is to remain in business.

Ener1, with a market cap of $641 million, is trading at a P/B ratio of 34.

PIPE Dreams

As my readers should know by now, a PIPE is a private investment in public equity. Hedge funds or other investors buy shares, often at a steep discount, and after a lock-up period (typically of 6 months or 1 year), they can then sell those shares to the public. Ener1 just filed a prospectus for the sale of 9% of the common stock outstanding. Keep in mind that the company will receive none of the proceeds of the stock sale; only the PIPE investors will benefit.

In a very negative sign, all but one of the investors listed in the prospectus has listed every single share they own for sale. While they will not necessarily sell every share, it is a bearish sign: in other prospectuses of PIPEd shares that I have seen it is common for holders to not list all their shares for sale.

Naive investors will often become more bullish when they see ‘smart money’ investing in their favorite speculative penny stock. However, PIPE investors do not need the stock price to go up to make money. As an illustration of how lucrative PIPE investing can be, consider the Quercus Trust, which is a trust for David and Monica Gelbaum (who have previously invested in some of my favorite companies, such as Octillion and Lighting Science Group). The trust is selling all 5.43 million shares (38 million pre-split shares) it owns.

Of those shares, 2.86 million shares (20 million pre-split) were bought last November for a total cost of $10 million (see the 13D for details). Warrants to buy the other 2.57 million shares (18 million pre-split) at a split-adjusted $5.25 per share were included in this purchase price. Here is the relevant excerpt from the 13D filing:

(1) The above reported 20,000,000 shares of Common Stock were acquired pursuant to Securities Purchase Agreement dated 11/19/2007, attached hereto as Exhibit B and incorporated herein by reference. In connection therewith, the Reporting Persons also acquired certain registration rights and warrants to purchase up to 18,000,000 shares of Common Stock, with an exercise price of $0.75 per share and an expiration date of 180 days following 11/19/2007. A copy of the Registration Rights Agreement dated 11/19/2007 and a form of Warrant to Purchase Common Stock of Ener1, Inc. are attached hereto as Exhibit C and D, respectively, and incorporated herein by reference. The total purchase price of the private placement (including both Common Stock and warrants to purchase Common Stock) was $10,000,000.

The Quercus trust exercised those warrants. At a recent stock price of $6.49, the 5.43 million shares held by the trust are worth $35.2 million. If the trust is able to sell these shares at the current market price, it will have reaped a profit of $11.7 million or 50% in under a year ($10 million was invested originally plus $13.5 million was used to exercise the warrants). In fact, the stock price would have to fall to $4.32 before the Quercus Trust starts to lose money.

Conclusion

Like in all areas of technology, either a few companies will come to dominate the market for advanced lithium batteries or the batteries will become commoditized and sell for low margins. An investment in Ener1 is a bet that it will come to dominate the market and that the market will be large. In every other possible situation the company would be unable to create enough sales and earnings to justify its current market capitalization. Even if it does become a large player in the battery market, it will need to raise hundreds of millions (if not billions) of dollars more in capital if it is is to produce the batteries. Such capital raising would likely be dilutive to current shareholders.

Unless you are an expert in the field and are absolutely sure that Ener1’s technology is better than its competitors’ technologies, I see much risk and little reward in investing in the company.

Further Reading:

Prospectus
10K for 2007 Fiscal Year
Quercus Trust 13D

Disclosure: I have no position in HEV. I have a disclosure policy.

SEC Ensures that Penny Stock Market Manipulation Remains Profitable

An SEC enforcement division press release today shows why penny stock manipulation remains popular and why I hate the SEC. According to the SEC:

“The Commission’s complaint alleged that, in August and September 2002, Hayden, Marc Duchesne, and others carried out a scheme to manipulate the price of Nationwide’s stock. The scheme was orchestrated by Duchesne, and began with a matched trade between Duchesne and Hayden that artificially inflated Nationwide’s stock price from pennies to $9.35 per share. The Complaint further alleged that, thereafter, Duchesne, Hayden, and others bought or sold Nationwide shares at inflated prices to increase the price of Nationwide stock, to generate volume, and to stimulate market demand for the manipulated shares. The scheme collapsed on October 1, 2002, when the Commission suspended trading in Nationwide securities. “

The judge “entered a Final Judgment of permanent injunction and other relief, including a bar against participating in offerings of penny stocks, against Jeffrey A. Hayden on May 7, 2008.” Hayden agreed to the judgment “without admitting or denying the Commission’s allegations.”

Midway through reading the press release I thought to myself, “Hey, maybe the SEC finally is starting to care about penny stock manipulation!” The description of the financial penalty imposed upon Hayden destroyed any last shreds of hope I might have had that the SEC cares about doing its job (emphasis mine):

“Hayden was liable for disgorgement of $290,798, together with prejudgment interest of $116,330, but payment of these amounts was waived based upon Hayden’s sworn Statement of Financial Condition. A civil penalty was not imposed for the same reason.”

There you have it! The only penalty to Hayden was a promise not to manipulate penny stocks. He did not have to pay one penny. That is less than a slap on the wrist. This is yet another reason why I believe that we should abolish the SEC and most stock regulations and instead pursue stock market fraud under the common law definition of fraud. Penalties would be far harsher and might actually scare people away from penny stock manipulation.

(Note–I am not a lawyer; if you are one and I am spouting nonsense, please let me know!)

The Coming Mortgage Crisis Part III: Low Interest Rates Do Not Make Housing More Affordable

Many people have argued that the current high house price to income ratio is not reason for house prices to decline, considering that interest rates are very low now. These people argue that what is important is not the actual price of the house, but the mortgage payment required to carry the house (for an example see user jcrash’s comments on my previous aritcles on the coming mortgage crisis at SeekingAlpha).

To some extent, these arguments are correct. Most home buyers use mortgages, and the difference in monthly payments between a 5.5% and a 8% mortgage is staggering. However, there are two important reasons why low interest rates do not mean that houses are affordable now: household debt is at an all-time high and mortgage rates will certainly go higher.

Total Debt Matters

Housing affordability is not independent of the affordability of other consumer goods. What matters for the affordability of housing and all consumer goods is the money available to pay for those goods (ie, money not spent on necessities). Total household debt is at an all-time high. The savings rate is close to zero. The most instructive number to look at is the household financial obligation ratio, or the ratio of income to household debt servicing and house or apartment-related expenses. To quote the Federal Reserve definition, “Debt payments consist of the estimated required payments on outstanding mortgage and consumer debt. The financial obligations ratio (FOR) adds automobile lease payments, rental payments on tenant-occupied property, homeowners’ insurance, and property tax payments to the debt service ratio.”

Keep in mind that these ratios do not include other non-discretionary expenses such as food and gasoline, the price of both of which has been increasing at staggering rates, which means that consumers have less ability to service their debt than even the following graph shows (click for a full-sized image). The data are available from the Federal Reserve. The key number to look at is the FOR Homeowner Total (light blue). Over the last decade this has increased from about 15% of income to about 19% of income.

for.pngThese are the costs on debt and home-related expenses that current homeowners pay. Because these are broad averages (many homeowners do not have mortgages after paying them off, reducing these ratios), it is important to look at the change over time. The ratio is currently about 4 percentage points higher than anytime prior to 2000. While this may not seem like much, consider that house prices are set on the margin and that approximately 40% of homeowners do not have mortgages. The marginal home buyer has much larger debt payments of all kinds than ever before, reducing his ability to buy. This alone indicates that home prices need to fall. However, the picture gets even bleaker when we look at mortgage rates.

Inflation Matters

Those that argue that house prices are affordable would agree that lower interest rates make houses more affordable, ceteris parabus. This is true not just for houses but for all capital assets. As interest rates increase, asset prices decrease. As interest rates fall, asset prices rise. If a buyer finances a high-priced asset with cheap financing and does not sell when financing becomes expensive, that buyer will do fine. However, a buyer who cannot hold indefinitely must pay attention to asset prices. Even when payments are equal, it is better to buy a cheap asset with expensive financing than to buy an expensive asset with cheap financing. The reason is simple: interest rates change. Interest rates are more likely to fall when they are high than when they are low. If they do fall, the seller who had bought when interest rates were high will have a capital gain as the price of the asset increases. However, the seller who buys when interest rates are low will take a capital loss if he sells after rates rise.

Inflation in the US is at a 4% annual rate as of March, and investors expect inflation to continue or get worse, as evidenced by the low yields on TIPS (Treasury Inflation Protected Securities). With 15- and 30-year fixed rate prime mortgages near their lowest rates since before the 1960s/1970s inflation epidemic, there is little place for mortgage rates to go but up. Even if housing were fairly affordable now (which the FOR ratios above show that it is not), higher interest rates will ensure that it becomes less affordable and that house prices need to continue to drop.

See Also

Option ARMageddon take on this issue

The Coming Mortgage Crisis: Part 1
The Coming Mortgage Crisis: Part 2

Disclosure: I have significant real estate holdings and I plan on selling short one or more regional banks.

The world’s greatest legal tax avoidance scheme: Ikea

Perhaps surprisingly, the Swedish giant Ikea wins the award as the greatest tax avoider in the world. Through numerous shell companies and a couple charities, the business is structured so that the sales and assets belong to a non-taxed charity, while the trademarks and other intangibles are privately-owned by shell companies headquartered in various tax havens. The net effect is that the charity spends very little money while being tightly controlled by the founder and the profits of the shell companies that earn the profits pay a whopping 2.5% tax rate on their profits.

See the Economist article (from 2006, but it was news to me).

Auditors and the SEC Cannot Protect Investors from Fraud

There are many fools investors who believe that the SEC and auditors will actively prevent companies from engaging in financial statement fraud. These people are wrong, as shown by the SEC’s lawsuit against GlobeTel (OTC BB: GTEM), which at various points in time while the alleged fraud was taking place traded on the Pink Sheets, OTC Bulletin Board, and AMEX. Yet despite having audited financial statements, its auditors did not find the underlying alleged fraud. The SEC’s complaint (pdf) alleges

violations that span more than five years and include fraud and the unregistered sale of more than $l .6 million in stock. These violations involved one scheme to fraudulently inflate GlobeTel’s revenue and then hide millions of dollars in unpaid bills,and another scheme to sell GlobeTel stock in order to pay some of the
individuals who were responsible for the fraudulent inflation of GlobeTel’s revenue.

If you invest in a company, make sure you can trust management. While there are clues that a company may be cooking its books, dishonest management can fool even sophisticated investors for a long time (as Enron famously did).

Disclosure: I have no position in GTEM. I have a disclosure policy.

The dumb way to steal from your investors

If a manager who runs a $30 million hedge fund decides to embezzle money, it usually makes sense to actually embezzle it and then run away, rather than just transferring it to a shell-company brokerage account and then losing half of it selling short Treasuries. Evidently someone forgot to give that sage advice to Matthew La Madrid and his hedge fund management company Plus Money. According to a recent SEC complaint:

The complaint further alleges that, unbeknownst to investors, in the fall 2007 Plus Money and La Madrid abandoned the covered call trading strategy, emptied out the monies in the Premium Return Funds’ brokerage accounts, and dissipated the money through a series of illicit transfers.

The SEC’s complaint alleges that investors were not told that in the fall 2007, La Madrid and Plus Money transferred nearly all monies from the Premium Return Funds’ brokerage accounts to Vision Quest Investments, a La Madrid dba, which in turn transferred $10 million to relief defendant Palladium Holding Company. The complaint further alleges that Palladium:

* Transferred $5 million to its own brokerage account and used the funds to trade in numerous short-sell transactions involving Treasury bonds; as of April 25, this activity had depleted more than half of the account’s value
* Wired $500,000 back to La Madrid
* Transferred $1.8 million to several real estate title companies
* Used $95,000 towards the purchase of two automobiles
* Transferred another $90,000 to a Denver-based car dealership

What I do not understand is why La Madrid did not simply make the losing bets in the hedge fund. If he had lost the money in the fund then he would have been guilty of little more than misleading his investors about his investment strategy (the fund was supposed to invest in covered calls).

Background checks are a good thing

Penny stock Energytec (OTC BB: EYTC) had found a new CEO, Don Lambert, and things looked good. However, according to the SEC, Lambert “failed to disclose his prior federal securities fraud conviction, his multiple bankruptcies, and that he had forfeited his Texas law license to avoid being disbarred.” One would think a public company, even a tiny company traded OTC, would think to do a background check or a credit check. But they didn’t. Because the company’s SEC filings did not include this material information, the SEC went after Lambert and made him pay a $50,000 fine. He consented to the judgment “without admitting or denying the allegations.”

Disclosure: I have no position in EYTC.

The Coming Mortgage Crisis: Part II

Things are different this time. That is what I argued in my previous post on the coming mortgage crisis. Exploding option ARMs will lead to record foreclosures, which will cause house prices to further decline, which will cause many households to have negative equity. Rather than pay mortgages that are larger than house values, people will simply walk away.

One additional factor that will cause great harm to the housing market is that many stated income loans fraudulently overstated income ( I almost committed mortgage fraud myself). Bond insurers and buyers of RMBS and CDOs will force these back onto the balance sheets of investment banks and mortgage originators, leading to a further decrease in lending and an increase in lending standards. This will increase the cost of buying a house and put further downward pressure on house prices. The Market Ticker blog has a good discussion of this problem and the harm it will cause to banks.

Following are a couple more graphs to support my case that the bubble is nowhere near finished deflating. The first is the average house price to income ratio across the US, courtesy of PIMCO.

pimco.jpg

The second is a beautiful graph of home prices in every city in the Case/Shiller home price index. This comes courtesy of The Mess that Greenspan Made blog.

tim.png

You can see from this graph that home prices have a long way to go before they return to pre-bubble levels. Cleveland and Detroit are back to the 2000 price levels, but the fundamental deterioration in those cities means that prices should fall further. Detroit and Cleveland have had declining populations for a number of years, and that trend continues. It is predicted that Detroit will continue to lose population and have only 705,000 residents in 2035, down from 890,000 in 2005.

Disclosure: I own real estate in St. Louis and Chicago. I have a short position in a land development company. I have a full disclosure policy.

Businessweek should fire Gene Marcial

Gene Marcial has been employed by Businessweek for a number of years, during which he has written his Inside Wall Street column. He is the main reason why I will never pay good money to subscribe to Businessweek. He has made more than a few bad calls over the years, but one of them is unforgivable. That call is his recommendation to buy Research Frontiers [[refr]] on July 30, 2007, just one day before I wrote that Research Frontiers was a ‘failed company‘. Since then, the stock is down 60% (see also my recent article on the company). The bigger problem is that Marcial was familiar with the company and wrote positively about it back in 1995 (link is not to the original article, which is not available online). A reasonable person might assume that if a company with a hot new technology just around the corner cannot get it to market in 12 years then that technology is not likely to ever be successful. Yet Marcial bought the company’s hype again 12 years later, believing that new contracts were just around the corner.

A word of advice to Mr. Marcial: it it looks like a duck and acts like a duck, it probably is a duck. If a company looks like a failed business that exists only on hype and selling more shares, then it is probably not a good idea to suggest that Businessweek readers to invest in it.

Jim Cramer’s words from The Fortune Tellers describe Marcial well: “this column has zero reliability … There he goes pumping some corrupt small-capper again.” 

A word of advice to the SEC: if you see fit to prosecute short sellers who benefit from spreading rumors, why not prosecute those in the media who spread rumors? While Marcial does not directly profit from the stocks he hypes, without hype and rumor he would likely be out of a job.

Disclosure: I have no position in REFR. I do currently subscribe to Businessweek, but I used expiring frequent flyer miles to pay for it. I have a disclosure policy.