Category: Microcap

Playing hot potato with the shares of an overvalued microcap

If you are not from Germany then the only time you have probably heard the term “Landesbank” is in relation to the subprime mortgage problem. WestLB and IKB required rescue from their owners after speculating and losing billions of dollars in subprime mortgage securities. Their peer NordLB (or for the German-speaking, Norddeutsche Landesbank Girozentrale) evidently decided to emulate WestLB’s and IKB’s idiocy by purchasing for a client 24% of perennially-overvalued microcap Remote MDX (OTC BB: RMDX). Now, normally this would not be a problem: if the client loses money the bank still gets its fees. However, the bank’s unnamed client refused to take the shares and those shares are now sitting on the bank’s books. NordLB recently filed a form 13D to announce this. Here is an excerpt:

Since November 2007, NORD/LB has been acquiring RemoteMDx Common Stock at the instruction of a client and with the intention to pass the shares on to the client. However, the client now refuses to accept the RemoteMDx Common Stock and to settle the orders. In the course of a review conducted with regard to these business activities, one of NORD/LB’s brokers mistook the trades for settled with the client and entered them into the books accordingly. Because the settlement process with NORD/LB’s client is still disputed, NORD/LB, as a matter of precaution, on February 25, 2008, assigned the shareholding to its own assets and is therefore making this disclosure on Schedule 13D. However, NORD/LB disclaims beneficial ownership of the shares of RemoteMDx Common Stock included in this Schedule 13D subject to resolution of this dispute.

The shares were purchased near the stock’s all-time highs. Whoever ends up with the shares will have a mark-to-market loss of $81 million, or 70%. No matter what happens, this situation makes NordLB look incredibly bad.

Note 3/16/08, 7pm: since I first published this I  was made aware that Carol Remond of DJ Newswires published an article about this Friday. She identified the client as Vatas GMBH, a previous 13D owner of RMDX stock. The hedge fund had also left Nord/LB with stock in several other microcaps.

For more information:

Remote MDX (RMDX.OB): A ‘Bit’ Overvalued (August 2007 – GoodeValue.com)
Remote MDX Redux (August 2007 – GoodeValue.com)

Citron Research Comments on Remote MDX (December 2007 – CitronResearch.com)

Disclosure: I have no position in RMDX.

Interim Performance Review

Your humble blogger is not averse to eating crow. So it is time to admit that I have been wrong so far about Frederick’s of Hollywood [[foh]] (Movie Star Inc prior to a recent reverse merger). It is difficult to invest without knowing all the information, and I appear to have been over-optimistic about the growth of the company. Especially with competitors like Limited Brands [[ltd]] (owner of Victoria’s Secret) selling quite cheaply, Frederick’s does not look like a worthwhile stock to buy. Frederick’s stock has recently fallen from $3.60 to $2.80 (its 52-week low after adjusting for a recent 2-for-1 reverse split).

On the other hand, my bearish advice continues to be very good: since scolding Patrick Byrne and Overstock.com [[ostk]] in a Dueling Fools article (for The Motley Fool), the stock has declined from $15.76 to $8.90.

In other news, despite Exmocare (OTC BB: EXMA, formerly 1-900 JACKPOT) being a horridly overvalued useless piece of trash with no sales and no significant book value and no chance of ever being worth one-tenth of its market cap, its stock has gone up since I pledged the profits from my short position in the stock to charity. The 1st Annual GoodeValue.com Short-a-Thon was a failure and raised $0 for charity.

Disclosure: I have no position in any stock mentioned. I trained in the dark arts of Jedi under the Sith Lord himself. My disclosure policy wants you to read it.

A worthless company that shall soon reward its foolish investors

Many things can be said about MaxLife Fund Corp (OTC BB: MXFD). Certainly, it could be called overvalued: the company, trading at a recent $18.89 per share and a market cap of $572.2 million (it has 30.3 million shares outstanding as of January 14), has a book value of $560,000 and revenues for the most recent quarter of $330,000. The company could be called a great speculation: since August 6, 2007 its share price has increased from $1 to $18.89. Since January its shares have doubled.

One thing that is certain about MaxLife Fund Corp is that it will not reward long-term investors. Even if the company does execute on its highly optimistic plan put forth in a recent press release (which I believe to be unlikely), its revenues and earnings will not justify its current market cap. One day its stockholders will realize this and the share price will crash down below $1.

Another ill omen for investors: Itamar (Eddy) Cohen is a 46% owner of the company. Stocks promoted by Cohen have not faired well: two of his recently promoted stocks have fallen 97% from their peaks.

For more information:

Forbes Informer article
10Q filing with SEC

Disclosure: I am short MXFD. I have a disclosure policy.

The fall of a pumped penny stock

I have previously written about Continental Fuels (OTC BB: CFUL) a number of times. I called it the most overvalued penny stock I had ever seen when it was trading around $2.50 per share (although there are now some good competitors for that honor). When its stock price had fallen to $0.70 per share, I said it remained 100-times overvalued. With a current stock price of $0.05 per share, I can finally say that the stock’s inevitable fall is mostly over (although it would still be a poor investment).

The moral of this story is do not invest in over-hyped stocks. Do not invest in stocks mentioned in spam emails, junk faxes, or junk mail. Do not invest in any individual stock unless you have read and understood its financial statements. For those who are not savvy investors, don’t worry: just invest in broad-market index funds and you will do better than most investors and mutual funds.

Disclosure: I have no position in CFUL.

Lighting Science Group: Yet Another Overvalued, Overhyped OTC BB Company

Lighting Science Group (OTC BB: LSCG) is a step above the everyday vermin that inhabit the OTC BB. It has two real businesses, one of which manufactures and distributes LEDs, and the other of which installs LED and other lighting systems. The one problem with Lighting Science is that its value as a real company is dwarfed by its market cap. In this way it resembles some other companies I have criticized in the past, including Continental Fuels (OTC BB: CFUL) and Noble Roman’s (OTC BB: NROM).

First, the market cap: with a total of 26.524 million shares (fully diluted) outstanding after its recent 1-for-20 reverse split, and a recent price of $9.90, Lighting Science has a fully diluted market cap of $263 million. The company has some sales and is a real business, but the thing it is best at selling is its shares: its share count has doubled in the past year alone (see the 10Q on page F-3 for details; this calculation excludes the 1-for-20 reverse split).

Book Value

Book value is something that cannot easily be faked. While different industries have different capital requirements, book value is a very good way to compare the size and intrinsic value of different companies in the same industry. As of September 30, 2007 (still according to the company’s 10Q), the company had a book value of $3.5 million. However, after a recent reverse merger with a private company, LED Holdings, the combined company has much greater book value of $24 million, including $16 million in cash (see the pro-forma financial statements).

Sales

The combined company (which will keep the name Lighting Science) had $5.7 million in sales for the first eight months of 2007. This is equal to an $8.5 million annual revenue run rate. This leaves the company with a stratospheric price to sales ratio (P/S) of 31, as compared to a P/S of just about 2 for GE [[ge]], one of the best and most consistent manufacturers, and a P/S of 6.5 for CREE [[cree]], a much larger manufacturer of LEDs.

I should note that LED Holdings has had a poor 2007 in terms of sales. Sales for all of 2006 were $8.9 million, but they fell to $3.7 million (a run rate of $7.4 million) in the first half of 2007.

Losses

While quickly increasing revenues is normally a good thing, it is not good to increase revenues and at the same time increase losses. Lighting Science’s (not including LED Holdings) loss over the first nine months of 2007 ($8.1 million) was 4.8 times greater than the loss over the same nine months in 2006. The third quarter 2007 loss of $4.8 million was 3.7 times larger than the 3rd quarter 2006 loss. LED Holdings, while being profitable over the last few years (with a profit of just over $1 million in 2006), has seen much slower growth in sales, and its profits in 2007 will be a lot lower than in 2006. The combined company would have had a pro-forma loss of $5 million over the first eight months of 2007.

PIPE Dreams

Longtime readers know of my disdain for PIPEs, or private investments in public equity. With penny stocks, these usually mean that a well-heeled investor gets shares at a deep discount to the market price and as soon as a six-month or year-long lockup period is over that investor will flip the shares onto the public for a tidy profit, even if the stock price of the company decreases.

Note 11 in the 10Q details a PIPE from a year ago in which the shares were placed for $0.30 ($6 per share, post-split). In addition to 0.667 million post-split shares, the investors also received (for free) 0.5 million post-split Class A Warrants and 0.667 million post-split Class B Warrants. The Class A Warrants give the holders the right to by the post-split stock at $7 per share. The Class B Warrants give the holder one full share and the right to buy 3/4 of a share at $6 (post-split) per share. Given a stock price of $9 (below the current $9.90), the the “PIPE-fitters” would have garnered themselves $8.5 million on an investment of $3.6 million ($9 per share times 0.667 million shares plus $2 per share times 0.5 million Class A Warrants plus $3 per share times 0.500 million Class B Warrants).

When PIPE investors do so well (more than doubling their investment in under a year), the company and its public shareholders do poorly. In return for a measly $3.6 million in cash (plus an extra $6.5 million when the warrants are exercised), shareholders were diluted by 1.667 million post-split shares with a market value of $15 million. If Lighting Science’s business were truly doing well, it surely could have found more advantageous funding sources.

La Revanche de David Gelbaum

Perhaps a good investment strategy would be to short sell any stock in which David Gelbaum invests. His Quercus Trust showed up as a large holder in Octillion (OTC BB: OCTL) and he is a large holder of Lighting Science.

[Edit 3/31/08: upon further review, I think it is more accurate to state that Gelbaum invests fairly indiscriminately in ‘green’ companies. So his investment does not mean much of anything, good or bad.]

Comparables

Perhaps the most comparable company to Lighting Science is CREE [[cree]]. It manufacturers LEDs and has some good technologies and patents. It trades at a P/S of 6.5 and a price to book ratio (P/B) of 2.7. If CREE is fairly valued and both it and Lighting Science deserve similar multiples, Lighting Science is overvalued by 500% according to the P/S ratio and by 430% according to P/B ratio. Being generous to Lighting Science, I would call it 400% overvalued and give my fair value estimate as $2.35 per share, one quarter the current price of $9.40. Of course, because Lighting Science is not profitable (unlike CREE) and is much less established, it deserves to trade at a significant discount to CREE. A 50% discount would be reasonable and would result in a fair value of around $1.20 per share (88% below the current market price).

A Bit of Positive Press

Perhaps you caught Jeff Bishop’s positive review of the company on SeekingAlpha. His article is entirely fluff. Furthermore, his company, Beacon Equity Research, has a nasty habit of covering a ton of OTC and Pink Sheets stocks and rating them “speculative buy” or “outperform”. I looked at over half of their reports, and all of the companies that were rated (one was not rated) were rated either “speculative buy” or “outperform”. Highly rated companies included such utter dreck as Rocket City Automotive and Universal Property Development and Acquisition Corp. Beacon is paid to cover most of the companies it covers, either directly by the companies or indirectly by large shareholders. That explains why Beacon is so overwhelmingly positive about the companies it covers.

Reverse Stock Split

Lighting Science recently completed a 20 for 1 reverse stock split, increasing the market price from around $0.48 to around $9.60. Academic research (pdf) has consistently found that companies that undergo reverse stock splits underperform the stock market drastically.

Conclusion

Lighting Science Group Co. is at best a halfway decent company that could eventually become profitable. At worst, it will continue to lose money for the foreseeable future. Either way, it is way overvalued. While LEDs will be a great market, there is little reason to believe that Lighting Science will be a leader in that market. It has too many competitors with more resources. If anything, my target price of $1.20 for Lighting Science is too high. I would argue that the comparable I used for the valuation, CREE, is overvalued as well. In fact, CREE is one of the most highly shorted companies on the NASDAQ.

Lighting Science Group Corp. is overvalued by any means. Smart investors should head for the exits and watch this company’s stock collapse from the sidelines.

For More Information

3rd Quarter 2007 10Q
Pro-Forma Financial Statements
LED Holdings Financials (and those of its predecessor company, LED Effects)

Disclosure: I am short LSCG. I have a full-disclosure policy.

Paye Tes Dettes!

The title of this post comes from the Charles Trenet song about the importance of paying off one’s debts (full lyrics).

In the search of good value we must be willing to take necessary risks. We must be willing to bet on struggling companies, sometimes with bad management, sometimes in struggling industries. We must never combine those three, however. Most important of all, we must shun excessive debt like the plague. While I prefer to avoid companies with significant debt, in cases in which the company has consistent earnings and the ability to maintain those earnings (because of strong brands or monopoly status), debt is forgivable.

For companies with tough competition and little competitive advantage, debt is a very, very bad idea. Two great cases in point are Movie Gallery (MOVI) and General Motors (GM). Both companies have historically strong brands and decent business models. They are both extraordinarily cheap. If they had less debt they would be great companies to buy. Saddled with debt, however, they lack the ability to survive their cut-throat industries.

Movie Gallery is a great example of stupid management harming a company. The company’s stock traded as high as $30 in 2005; it now trades at $4. Movie Gallery runs a chain of video rental stores. They have historically been profitable. However, early in 2005 the company took on much debt to buy Hollywood Video. The company now has a market cap of $130 million and debt of $1.1 billion.

I would argue that the movie rental business is one of the best businesses to be in. People like watching movies, new movies cost a lot to see at movie theaters, and the competition (satellite and cable movies on demand) are not that great. While Netflix (NFLX) has made it harder for bricks and mortar stores, I feel its impact has been drastically over-rated. I subscribe to the Netflix service, but there are plenty of people who do not. A bricks and mortar store can do good business because those that rent less frequently will not subscribe to Netflix.

Therefore, I think that Movie Gallery’s two chains, Movie Gallery and Hollywood Video, will still be around in one form or another fifteen years from now. The problem is that the debt of the current company will likely result in bankruptcy and leave the stock worthless.

General Motors faces much the same problem. Unfortunately for the careless investor, their full debt his hidden in details in their financial statements about their union contracts and the number of retirees for whom they provide pensions. Some have estimated that GM will have to pay out over $70 billion in pensions and health care benefits to its current and future retirees. For a company that has consistently lost a few billion dollars per year over the last few years, this is a problem.

In addition to its debt, GM has too many brands, too much production capacity, an unfavorable union contract, and shrinking sales. Without such a sizable debt, GM would stand a chance of restructuring and saving its stockholders. As it stands, it has no room to maneuver. Unless it can become highly profitable within a year or at most two years, it will go bankrupt.

So does debt matter for stock returns? Yes, at least according to “Predictability of UK Stock Returns by Using Debt Ratios” by Muradoglu and Whittington (scroll down on the page to which I link to download the PDF). While the data are from the UK, the results are logical and should apply in the USA as well. While the correlation of debt ratio with stock returns is lower than the correlation of P/E with stock returns, there is still a definite negative correlation: the stock of those companies with the least debt did the best. The 30% of companies with the lowest debt showed a consistent advantage over those with higher debt. Those companies had gearing ratios (leverage ratios for you Americans) of under 20%, meaning that total debt represented less than 20% of enterprise value. There are other ways of reporting leverage but I like this one. For comparison, MOVI has a gearing ratio of 89%, while GM has a gearing ratio of 96%.

Disclosure: I have no position in any company mentioned. This was originally written two years ago and published elsewhere. Movie Gallery has since declared bankruptcy. I have a disclosure policy.

Cytocore: Management by Hype and Distortion

It is one thing for a speculative company low on cash to get more money in a PIPE at a discount to the stock’s market price. It is quite another for such a company to give that opportunity to insiders and then to shamelessly announce in a press release that it was good news. Yet this is exactly what Cytocore (OTC BB: CYOE) just did. Daniel Burns (a director) and Robert McCullogh (CFO and CEO) each purchased a large number of shares from the company for $2 per share on January 22. This was an 18% discount to the stock’s close that day. And still the fools who “invest” in the company’s stock rejoiced by pushing the share price up 51% in the three weeks since then.

At the end of the quarter ended September 30, 2007, Cytocore had under $1 million in cash and a negative cashflow from operations of about $1.5 million per quarter. So despite what the press release said, this was not an investment to “assist in the scale up” of the company’s manufacturing, but rather a necessary investment to keep the company up and running.

I have written about Cytocore’s travails before and I have received some kind comments in response to my previous article.

Disclosure: I have no position in CYOE, although I do confess to a visceral hatred of a few of the company’s investors. I have a disclosure policy. An earlier version of this article referred to the cash flow from operations as the cash burn rate. This was incorrect and I regret the error (there was negligible cash burn over the last 9 months due to the sale of stock and the exercise of warrants).

Document Security Systems Getting Desperate for Cash

I just ran across an interesting article on SeekingAlpha on my old friend Document Security Systems [[dmc]]. The author of the article is short DMC, so take it with a grain of salt, but he does bring up some good points, including some past failures for the company’s new Chairman of the Board. Shareholders will be very disappointed if the company does not actually collect any cash from its patent lawsuits. If that happens, his estimation that the stock could fall 85% seems conservative.

When I last wrote about Document Security Systems, I was decidedly negative. The stock price has since fallen by 50%.

For more information, see DMC’s most recent 10Q.

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

Update on my stock picks and pans

My bearish calls have been pretty accurate over the last couple months. Life is not too good right now if you were an investor in Cellcyte Genetics (OTC BB: CCYG), Noble Roman’s (OTC BB: NROM), or Octillion (OTC BB: OCTL). After having almost doubled since I wrote about it, Cellcyte has now fallen 90%. Noble Roman’s is down over 40% since I first wrote about it. Octillion is down over 60% since I wrote about it.

Home Solutions of America (OTC: HSOA) is down over 80% since I first highlighted questions regarding fraud. Skinns (OTC BB: SKNN) is down 30% since I called its whole business ‘silly‘ while praising the quality of management. My old favorite, Continental Fuels (OTC BB: CFUL), is down 25% since the most recent time I mentioned how overvalued it was.

My recent positive calls have been few and far between. I was positive on TSR Inc. [[tsri]] and I still am. It is down only slightly since I wrote about it in mid-December, about in line with the market. Also, my positive call on Tecumsah [[tecua]] has been a good call.

While basking in my glory, I should also highlight my painfully bad call on ACA from last August, after which it fell 90%. (I blame this on my call being on video and not in writing.) In my defense, I did say that I did not understand the company enough to invest in it.  IDO Security (OTC BB: IDOI) has also been a bad call. Since I wrote about its promotion by junk fax the stock is up over 40%. It will eventually go back down, however.

Disclosure: I am long TSRI and have no other position in any stock mentioned. I have an iron-clad disclosure policy.

I Matter!

The mark of someone who is making a difference is that they make enemies. I guess someone thinks I’m making a difference! Dan said this to me in response to my article on CytoCore (OTC BB: CYOE):

Your article on CytoCore was total [bull feces]. Seems a little odd to have picked
it out of the blue. A virtual unknown company that you decide to short.

Seem to be trying to gain financially off the article. Best watch your [derrière].
Front and back.

Dan, if you had bothered to research me you would have found out that almost all the companies about which I write are tiny and unknown. Also, watching my tush “front and back” makes no sense. Oh, and I have never shorted Cytocore.

Disclosure: I have never shorted Cytocore. My disclosure policy, though high on life, is far more lucid than Dan.