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Whitney Tilson - I've Never Seen More 'Target Rich' Shorts Other Than Late 1999 and 2007

September 11, 2013 | About:
Whitney Tilson wrote the following in a letter to his followers detailing his four main short ideas:


I have two strong feelings about shorting right now:

a) It’s a horrible business, it’s cost me a fortune over the past 4½ years, I wish I’d never heard of it, and every bone in my body wants to cover every stock I’m short and never short another stock again; and

b) In my 15 year career of professional investing, the only other times that have been as target-rich in terms of juicy, obvious shorts are late 1999/early 2000 and late 2007/early 2008 (and we all know how those ended…).

So which feeling am I going to follow (I feel like John Belushi in that famous scene in Animal house, with the angel on one shoulder and the devil on the other…)? I don’t know, but this I know for sure: the only other time I felt like covering every short and becoming a long-only manager was October 2007. So I went through my short book, stock by stock, and said, “OK, am I willing to cover MBIA at $70? Hell no, not a single share! Allied Capital at $30? Hell no, not a single share! Farmer Mac at $30? Hell no, not a single share!” And on it went… I couldn’t bring myself to cover a single share of any stock I was short – they were all “trembling-with-greed” shorts.

And that’s exactly how I feel today…

So I’m going to stick my next out and share my views on four battleground stocks that are among my favorite shorts: World Acceptance (WRLD), Green Mountain (GMCR), Herbalife (HLF), and InterOil (IOC). And next week at the Value Investing Congress I will present another short, my largest.

2) Let’s start with an easy one, World Acceptance (WRLD), which I first wrote about in my email on 5/19 (let me know if you want me to resend you this email). Here is what I wrote in my Q2 letter to investors about it:

World Acceptance

World Acceptance is an installment lender that makes small, unsecured loans to subprime borrowers via 1,203 offices in 13 states and Mexico. It has highly attractive financial characteristics and has grown strongly for many years, leading to exceptional stock performance. Keep in mind, however, that these statements also characterized subprime mortgage lenders like Countrywide up to the peak of the housing bubble – just before they collapsed. Like them, I believe that World Acceptance is a truly predatory company, victimizing and exploiting its customers with usurious interest rates, outrageous fees, and overpriced, unnecessary credit insurance. This business is so shady and exploitative that it is effectively outlawed in all but the 13 states World Acceptance operates in.

I became aware of the company by reading an expose published by ProPublica, which has won two Pulitzer Prizes for its investigative journalism. Its series of articles on World Acceptance is an extraordinary piece of work that lays out in detail the many ways in which the company deceives and defrauds its customers. Here are the highlights (lowlights) from the series:

Repeat Refinancing of Delinquent Borrowers

· “In every World office, employees say, there were loan files that had grown inches thick after dozens of renewals.” “That’s [World’s] favorite phrase: ‘Pay and renew, pay and renew, pay and renew,’” Simmons said. “It was drilled into us.” It’s a tempting offer: Instead of just scrambling for the money to make that month’s payment, the borrower gets some money back. And the renewal pushes the loan’s next due date 30 days into the future, buying time.”

· “For Sutton, making her monthly payments was always a struggle. She remembered that when she called World to let them know she was going to be late with a payment, they insisted that she come in and renew the loan instead.”

· World’s credit quality is a fiction, a substantial number of customers can’t repay and are repeatedly refinanced. “At World, a normal month begins with about 30 percent of customers late on their payments, former employees recalled.”

Comments on Deceptive Sales of Credit Insurance

· “Former World employees say they were instructed not to tell customers the insurance is voluntary.”

· “World can legally understate the true cost of credit because of loopholes in federal law that allow lenders to package nearly useless insurance products with their loans and omit their cost when calculating the annual rate.”

· “As part of her loan, Sutton purchased credit life insurance, credit disability insurance, automobile insurance and non-recording insurance. She, like other borrowers ProPublica interviewed, cannot tell you what any of them are for: ‘They talk so fast when you get that loan. They go right through it, real gibberish.’”

· “‘Every new person who came in, we always hit and maximized with the insurance,’ said Matthew Thacker, who worked as an assistant manager at a World branch in Tifton, Ga., from 2006 to 2007. ‘That was money that went back to the company.’”

· “When insurance products are optional — meaning the borrower can deny coverage but still get the loan — borrowers must sign a form saying they understand that. ‘We were told not to point that out,’ said Thacker, the former Tifton, Ga., assistant manager.”

· “‘You were supposed to tell the customer you could not do the loan without them purchasing all of the insurance products, and you never said ‘purchase,’’ Buys recalled. ‘You said they are ‘included with the loan’ and focused on how wonderful they are.’”

· A regional supervisor threatened to discipline a sales person for advising customers that the insurance was voluntary.

· World’s systems don’t let a customer to decline the optional insurance: “But World soon made it harder to remove the insurance premiums,’ Buys said. She couldn’t remove them herself but instead had to submit a form, along with a letter from the customer, to World’s central office. That office, she said, sometimes required borrowers to purchase the insurance in order to get the loans.”

Threatening Customers in Violation of FTC rules

· “If the phone calls don’t work, the next step is to visit the customer at home: “chasing,” in the company lingo. ‘If somebody hung up on us, we would go chase their house,’ said Kristin from Texas. The experience can be intimidating for customers, especially when coupled with threats to seize their possessions, but the former employees said they dreaded it, too. ‘That was the scariest part,’ recalled Thacker, a former Marine, who as part of his job at World often found himself driving, in the evening, deep into the Georgia countryside to knock on a borrower’s door.”

· “Visits to the borrower’s workplace are also common. The visits and calls at work often continue even after borrowers ask the company to stop, according to complaints from World customers to the Federal Trade Commission. Some borrowers complained the company’s harassment risked getting them fired.”

· World also threatened to collect personal possessions pledged as collateral even though the FTC bars pledging “household goods” such as a TV and furniture.

The Consumer Financial Protection Bureau was established precisely to combat practices like World’s. As the ProPublica article notes:

The Consumer Financial Protection Bureau…has the power to sue nonbank lenders for violating federal laws. It could also make larger installment lenders subject to regular examinations, but it hasn’t yet done so. Installment companies have supported Republican efforts to weaken the agency, echoing concerns raised by the lending industry as a whole.

Will the CFPB act to rein in World and its ilk? I think it’s likely, as it’s already acting against payday lenders, which utilize similar techniques to victimize consumers. In April, the CFPB released a report entitled Payday Loans & Deposit Advance Products, which the Wall Street Journal covered in an article entitled, U.S. Regulators to Warn Against Payday-Style Loans:

Federal regulators are preparing to crack down on short-term payday loans and similar products offered by banks after concluding they trap consumers into taking on debt that they can’t repay.

The Office of the Comptroller of the Currency and Federal Deposit Insurance Corp., in an effort to prevent so-called direct deposit advance loans, plan to warn banks against offering such products and erect hurdles for those that continue doing so, said people familiar with the matter.

The regulators plan to issue guidance mandating that banks evaluate consumers’ ability to repay such loans and limit how often they can make repeated loans to the same customer.

Meanwhile, the Consumer Financial Protection Bureau said it also intends to throw up roadblocks to payday loans, suggesting it could limit the number of consecutive loans to discourage consumers from taking on too much debt.

The CFPB, in a report to be released Wednesday, said it expects to use its authority to provide consumer protections to loans issued by nonbank lenders.

Dennis Shaul, chief executive of the Community Financial Services Association of America, which represents payday lenders, said his industry would “work with the CFPB to ensure payday loans are a safe, reliable option for the millions of consumers who need access” to short-term loans.

The crackdown comes amid criticism of short-term loans that are intended to help consumers through a financial rough patch but can quickly trap them in a cycle of debt, in which they need to take out subsequent loans to pay debts they have already incurred.

What’s the proper price for the stock of a highly levered financial company doing unsecured lending to subprime customers, facing potentially crippling regulatory action? I’d argue that 1x book value would be generous, especially in light of questionable loss reserves. Yet World’s shares trade at 3x book value, so I think the stock has at least 67% downside – and I wouldn’t rule out a zero. Simply put, this business should not exist.

In late July the company finally issued its 10K, which was delayed, and dropped these bombs (which are most definitely NOT boilerplate):

Management's assessment of the Company's internal control over financial reporting identified a material weakness related to the documentation of the establishment and assumptions underlying the adequacy of the allowance for loan losses and the documentation of management's assessment of renewals that may be considered loan modifications as of March 31, 2013…

…The material weakness resulted from the aggregation of the following deficiencies:

• The Company did not have a documented policy that addressed the establishment of the allowance for loan losses, including the assumptions underlying the allowance for loan losses and how management would review and conclude on the appropriateness of the allowance for loan losses; and

• The Company did not have a control to assess whether the accounting treatment of renewals was in accordance with U.S. generally accepted accounting principles and what impact, if any, renewals would have on the estimate of the allowance for loan losses

So I guess it shouldn’t be surprising that WRLD released the news that its CFO, Kelly Malson, “retired” after the close today, which was obviously very sudden given that the company hasn’t even begun a search for a new CFO and Malson didn’t leave for another job:

World Acceptance Corporation Announces Planned Retirement of Chief Financial Officer

Press Release: World Acceptance Corporation – 46 minutes ago

GREENVILLE, S.C.--(BUSINESS WIRE)--World Acceptance Corporation (NASDAQ: WRLD) today announced that Kelly M. Malson plans to retire from her position as Senior Vice President and Chief Financial Officer of the Company. The Company will initiate a search for a new CFO, and the exact timing of Ms. Malson’s departure will depend on the Company’s process for finding a successor. Malson’s eight-year tenure with the Company began in 2005, and she has served as the Company’s Chief Financial Officer of the since March 2006.

“I want to thank Kelly for her service and many valuable contributions to our Company as CFO and a key member of our senior management team,” said Sandy McLean, the Company’s Chairman and Chief Executive Officer. “Her leadership and dedication have been critical to our success and the development of our finance function and team. Although we are sorry to see her leave, we respect Kelly’s decision and desire to pursue other objectives and wish her all the best in those endeavors.”

“I am honored to be a part of the World Acceptance team and to have had the opportunity to work together with so many talented and dedicated colleagues to grow our Company and position it for continued success,” said Malson. “I look forward to supporting the Company in a smooth transition and thereafter pursuing other life objectives.”

(Note that the Malson is also the Chair of the audit committee of CONN, another HIGHLY questionable company…)

3) Now let’s turn to Green Mountain (GMCR). Jesse Eisinger, one of the best investigative journalists around, raises some very good questions about the company and its accounting in his column today, which begins:

Green Mountain Coffee Roasters’ first-ever investor day is Tuesday, and the company is flying high.

The stock price of the company, which sells coffee machines under the Keurig brand and the little K-Cups that go in them, has soared more than 260 percent in the last year.

Despite persistent questions, most of Wall Street remains resolutely bullish on Green Mountain, which has a market value of $12 billion.

In 2010, the company disclosed it was being investigated by the Securities and Exchange Commission. In 2011, the hedge fund manager David Einhorn, who is betting against Green Mountain’s stock price, delivered a highly critical 110-slide speech at an investor conference, raising questions about the company’s future prospects and, more seriously, its bookkeeping. He followed up a year later with another one.

A class-action lawsuit, which was dismissed, quoted anonymous former employees about suspicious activities. Green Mountain has said it conducted an internal investigation that cleared the company.

Green Mountain operates on a razor/razor blade model — selling brewing machines but making its real money on the K-Cups. It used to disclose exactly how many K-Cups it sold but stopped doing so in 2010. Instead, it tells investors the year-over-year percentage growth. Wall Street has dutifully plugged numbers in to estimate the unit sales.

Last year, Green Mountain faced expirations of the patents that covered its brewing system. Wall Street has been monitoring whether Green Mountain will lose market share to new private-label knockoffs. And indeed, a recent Barron’s article suggested that it was losing share faster than expected.

A recent disclosure from the company’s new chief executive, Brian Kelley, has revived the questions about sales, as do on-the-ground accounts I have received from former factory and warehouse workers.

Because Green Mountain’s investor day will give analysts and shareholders unusual access to company executives, it seems like an opportunity to ask them some hard questions.

Here are a few from me.

■ Just how many K-Cups has Green Mountain sold year-to-date and is it less than the Street understands?...

■ How wide is the gap between how many K-Cups the company says it has sold and how many have ended up in customer’s hands? And why?...

■ What explains the unusual movements of Green Mountain inventory described by some former company workers and associates?...

■ What is happening with the S.E.C.’s investigation of Green Mountain, which the company has said involves its accounting practices?...

Let’s take a closer look at K-Cups, where the math just doesn’t make sense – and the company isn’t helping with an explanation. At the analyst day today (see webcast and 188-slide presentation at: http://investor.gmcr.com/index.cfm), the company was asked to reconcile this estimate of K-Cups (since, as Eisinger notes, the company stopped disclosing K-Cup sales in 2010): there are 16 million brewers, GMCR claims usage (an “attachment rate”) of 1.4 K-Cups per day x 365 days/year, which results in sales of 8.2 billion K-Cups per year (which doesn’t even count maybe 15-20% additional consumption away from home). But GMCR isn’t selling anything close to this number of K-Cups, per both analysts and the company (see Eisinger’s article below), so what gives? My answer: usage is declining. It makes sense that the people who bought brewers first are likely to be the heaviest users, so the company and analysts should be modeling declining attachment rates – but of course they’re not.

When asked about this at the analyst day today, three people from management started speaking at the same time and eventually the CEO said “We don’t do straight math.” Now that’s a quote for the ages!

An even greater concern is that 700-900 MILLION K-Cups can’t be accounted for. Eisinger writes:

That’s a far cry from 5.6 billion. There seems to be a gap in the United States of about 900 million K-Cups.

What’s going on?

Mr. Brandt said the company declined to give its overall sales volume, but said the IRI number that I was furnished with was too low. He said a company analysis indicated that this portion of Green Mountain’s sales should be about 2.7 billion, not 2.6 billion.

Still, even if we use the company’s figure of 2.7 billion, total sales in the United States would be 4.9 billion, or about 700 million K-Cups short of what the company has said. That’s a lot of extra K-Cups sitting in the channel.

Maybe I’m just being paranoid, but I’ve seen this kind of thing before: in many of the China frauds, companies were booking fake sales, resulting in fake profits. But that leads to a big problem for the companies: it’s hard to fake all the cash that should be in the bank as a result of the supposed profits. The solution? Fake/overpriced/fraudulent acquisitions and/or cap ex to reduce the cash (that was, of course, never there).

Now go back and read David Einhorn’s 110-slide presentation on GMCR at the Value Investing Congress on Oct. 17, 2011 (posted here: http://blogs.wsj.com/deals/2011/10/19/heres-the-einhorn-presentation-that-killed-green-mountain-shares) and look at the high-priced acquisitions on pages 50-53 and especially pages 68-72 on cap ex. Einhorn calculates that $431 million (58%) of GMCR’s cap ex is “unexplained” and concludes:

• Capital spending is growing much faster than the business

• Capital intensity should be getting more efficient as the company achieves scale

• The gap is so large and insufficiently explained that it raises questions about what is being capitalized and casts doubt on the business model

Einhorn gave an update on GMCR in his presentation at the Congress on Oct. 2, 2012. He didn’t release the slides, but here are some of my notes:

GMCR’s cap ex as a percentage of sales was 11.0% in 2011, 13.1% (est.) in 2012, and 9.2% (guidance) in 2013. Compare this to the 3.3% average in the food products industry, with a range of 1.0% to 6.3%.

GMCR’s cumulative cap ex from 2007-2012 was $1.043 billion and K-Cup shipments in 2012 were 7.1 billion. Divide these two and you get 14.7 cents of cap ex over six years for each K-Cup produced in 2012. Compare this to Einhorn’s analysis of a competitor, which spent 3.8 cents for each K-Cup produced (buying the same production equipment as GMCR). Again, MASSIVE unexplained cap ex.

Einhorn then turned to the production capacity that GMCR’s competitors were bringing online and estimated that they would have enough capacity to take 19% market share by the end of 2012 and 26% by the end of 2013.

Lastly, Einhorn showed that competitors were already selling K-Cups for 22-39% less than GMCR was, and highlighted price cuts GMCR had taken that would wipe out nearly all of its profit.

(Obviously these last two things haven’t occurred yet – but that doesn’t mean they won’t…)

Is GMCR committing massive accounting fraud? I don’t know – and I certainly can’t prove it – but there are a number of warning flags, so I sure can’t rule it out. The company could easily put a lot of these concerns to rest by providing some obvious disclosure – like number of K-Cups sold – but refuses to (despite providing highly granular disclosure on most other matters – see today’s 188-slide presentation today, for example), which makes me all the more suspicious…

The nice thing about GMCR as a short is that I think it’s a good one even if it’s accounting is clean because of its very high valuation (29x trailing EPS and 22x FYE 9/14 estimates (if you believe them)) combined with its patent loss a year ago, which is resulting in a ton of low-cost competition entering the market (see page 44-48 of Einhorn’s 2011 presentation and my notes from his 2012 presentation above).

It’s almost never pretty when a company with a monopoly market share and monopolistic pricing begins to face competition from low-cost generic producers (think what happens when a drug goes off patent) – but it can take some time for the competition to emerge and impact the monopolist’s financials, during which time the monopolist can give whatever guidance it wants (and you can be sure that Wall St. “analysts” won’t question the pie-in-the-sky guidance). Witness today’s analyst day…

4) Attached is Bill Ackman’s latest salvo against Herbalife. I’ve deliberately not engaged in this war and don’t intend to write or speak about it further because a) it’s such a war and b) I don’t need the brain damage, but I’m convinced that Ackman is right that it’s a pyramid scheme. It’s a very clever one, however, because there’s just enough of a legitimate business that anyone who’s predisposed to conclude that it’s legitimate (or just wants to stick it to Ackman – see Icahn, Carl) can easily find evidence that there are some real sales and consumption. But as Charlie Munger once famously said: “If you mix raisins and turds, they're still turds.”

Of course it’s possible that HLF could be a pyramid scheme, but not be a good short. For the short to work, one or both of the following must happen:

a) There’s a slowdown in the number of new suckers/victims that are needed to enter the bottom of the pyramid each year to maintain it, perhaps because the truth about HLF becomes widely known or the law of large numbers catches up with HLF; and/or

b) Regulators/auditors must act to rein in HLF.

I think the latter is more likely, but I don’t think it’ll be a sudden thing – for example, how regulators shut down Fortune Hi-Tech Marketing (see:www.bloomberg.com/news/2013-01-28/direct-seller-fortune-hi-tech-marketing-accused-of-fraud-1-.html). Rather, I think it’s more likely to play out like the for-profit ed industry, where a combination of running out of suckers combined with more scrutiny and tighter regulation resulted in this stock chart of the past two years of ESI, APOL and CECO:

5) Last but not least, an old favorite short, InterOil (believe it or not, this one is still going on!). Here’s what I wrote in my Q2 letter:


I believe InterOil is one of the largest promotions of all time – but unfortunately (so far) for anyone short the stock, it’s also one of the cleverest. The company, which has all sorts of associations with questionable characters (and pretty much every other red flag a short seller looks for), has been drilling for natural gas in Papua New Guinea for well over a decade and has repeatedly claimed to have found the mother lode – only to disappoint investors again and again (see Appendix B for a remarkable and telling series of unfulfilled promises from the company and its founding CEO, Phil Mulacek, dating back to 2007). One would think investors would finally wise up, but to date they haven’t, as the company currently sports a $3.4 billion market cap.

This valuation is based on the expectation that InterOil has discovered one of the world’s largest natural gas fields and that current negotiations with ExxonMobil will result in an extremely lucrative deal for InterOil. I think the odds of this are close to zero.

To be clear, nobody – not InterOil’s management nor any outsider – knows with certainty whether the company has a real resource discovery or not. This isn’t a fraud like Bre-X (for those of you with long memories) because there really is some gas in InterOil’s fields, which makes it almost impossible to disprove the company’s claims. Instead, one has to analyze geological reports, look at the track record of the company’s promises, examine the background of the key people, and then apply common sense.

Here are the key facts: after 15 years of drilling, InterOil still has no proven, probable or possible reserves (nothing but a “contingent resource estimate” by a company well paid by InterOil); its founding CEO unexpectedly quit recently (when was the last time this event was followed by great news?); the company continues to burn enormous amounts of cash; and after hyping a bidding war among multiple major oil companies, is currently only negotiating with one, ExxonMobil (think about who’s likely to have the upper hand in those negotiations…).

Here is my analysis of what InterOil told its investors in a presentation at its annual meeting on June 24th:

· What the company said: “Monetizing sufficient resource to cover our share of infrastructure costs and fund exploration while retaining maximum upside for IOC equity interest.”

What I think it really means: ExxonMobil will take a huge amount of the upside from whatever InterOil might have in exchange for a small amount of money to cover InterOil’s ongoing “infrastructure costs and fund exploration.”

· What the company said: “Post-negotiations, InterOil and Pacific LNG have clear path to resource monetization.”

What I think it really means: ExxonMobil only agrees to pay InterOil anything material if it’s actually discovered a major field.

· What the company said: “There will be staged payments before and after production commences to compensate for resource revisions.”

What I think it really means: Nobody knows how much natural gas (if any) InterOil actually has so, again, ExxonMobil will only agree to pay InterOil anything material if it actually has a major find.

· What the company said: “The purchase of an interest in PRL 15 is not contingent on resource recertification.”

What I think it really means: ExxonMobil will take a stake in InterOil’s resource now, prior to resource recertification, most likely in exchange for a de minimis amount of money.

· What the company said: “The resource recertification will be used to determine the economic interest in the license and to allocate upstream capital costs.”

What I think it really means: There will definitely be a resource recertification and all of the economics of the deal will be contingent upon what it shows.

Overall, this makes it clear that ExxonMobil has little confidence that InterOil has discovered anything, but is happy to get a nearly-free call option in the (very small) chance that InterOil really has discovered a huge resource.

Appendix B: Endless False Promises from InterOil and Its Founding CEO, Phil Mulachek

· We are in discussions, a vast number of companies on at least three continents have expressed interest joining our acreage following the Elk-1 discovery and flow test.

- Mulacek April 4, 2007

· “Strategic industry partner… who has extensive LNG experience” will deposit $42.5mm for 5% of LNG project.

- InterOil Press Release May 24, 2007

· Over the next quarter, going forward, we look to close the farm-in of our first strategic LNG partner.

- Mulacek Aug. 14, 2008

· Detailed discussions continue with potential strategic investors as we target a sale of 20% to 25%.

- Mulacek Feb. 25, 2009

· European partners have been talking to us.

- Mulacek Feb. 25, 2009

· A number of Japanese companies approach[ed] us, and we are in discussions... over thenext two to three months.

- Mulacek May 20, 2009

· We [gave] access to 30 companies interested [in the project]. We are now trimming [them] down to a few groups.

- Mulacek July 9, 2009

· We are now in the final qualification and final scoping phase of our LNG program with strategic partners.

- Mulacek Aug. 9, 2009

· It [InterOil] aims to find a partner to back the project “over the next couple of months” and to make a final investment decision in about a year.

- Wayne Andrews via Bloomberg Dec. 24, 2009

· We have a number of options in place or under discussion on financing, most of which are tied to our strategic partnering process.

- Mulacek March 2, 2010

· We expect (to) start construction this year after FEED and FID are agreed.

- Mulacek Aug. 4, 2010

· We target FID on the condensate plant by the end of the first quarter of 2011 and the LNG plant by mid-2011.

- Mulacek Nov. 16, 2010

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Canadian Value

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