THE name sends shivers around trading desks across the region. In just over two years, Carson Block has emerged from obscurity to being probably the best-known short-seller in Asia. Five weeks ago, the 36-year-old American quietly slipped into Singapore and showed up at soft-commodity supply-chain manager Olam International's headquarters, piggy-backing on a hedge-fund-manager friend, to question the company's business model.
Since Nov 19, the man who single-handedly brought down Toronto-listed Sino-Forest Corp has been a constant thorn in the side of Olam, attacking the firm with reports and statements after building up a short position in its stock and bonds.
Who is Block? What does he really want? Why is he doing what he is doing to Olam? And will Olam's latest move to bolster its capital squeeze short-sellers like him or will the shortist bide his time and keep sniping away at his latest target? By his own admission, Block has a game plan in his relentless pursuit of profits from shorting. He insists he is in Olam because he believes he can profit from shorting its stock and bonds and, indeed, already smells blood.
Block's mentor is hedge-fund pioneer and legendary shortist Michael Steinhardt and he is an admirer of short-seller Jim Chanos, founder of Kynikos Associates, a long-time proponent of the view that short-sellers are "real-time financial detectives".
To be sure, investment research runs in Block's blood. His father, William, was a Wall Street broker who later set up his own boutique investment research firm in California, where the younger Block cut his teeth as an intern. After obtaining a degree in finance and Chinese from the University of Southern California, Block got a law degree from Chicago-Kent College of Law. He arrived in Shanghai eight years ago to work as a corporate lawyer, but left to start a self-storage firm and later to co-author a book, Doing Business in China for Dummies, on his experience as an entrepreneur in Shanghai.
While he was still working on the book, Block got his first investment research assignment from his Dad: to look at a reverse-merger stock called Orient Paper. The elder Block was hoping to invest in Orient Paper at the time. Following a scathing report by his son, William shorted Orient Paper's stock, which plunged nearly 70%, reaping him huge profits. The younger Block then launched an independent research house by posting his Orient Paper report on a website dubbed Muddy Waters, after the nickname of American blues musician McKinley Morganfield. Over the past two years, he has been responsible for the collapse of Chinese reverse-merger companies in the US. Block recently spoke to The Edge Singapore from San Francisco. The following are excerpts from the 70-minute interview.
Let's start with your track record as a short-seller. Your critics say you have clearly stumbled since Sino-Forest.
We put out our first research in June 2010 on a Chinese reverse-merger company, Orient Paper. The stock fell from US$9 to just US$2 and the only people who still maintain it is not a fraud is the company itself. The second company was RINO International, which actually admitted it was a fraud. Then, there was China Media Express, which Deloitte Touche Tohmatsu called a fraud. Duoyuan Global Water was next, and everybody resigned from it. Last year, we looked at Sino-Forest, and I don't have to tell you what happened there.
After Sino-Forest, we started going after IPO stocks rather than reverse mergers. We basically targeted two companies — Focus Media and New Oriental Education. After Sino-Forest, the Chinese government really decided to protect the frauds. My theory is that they were worried that short-sellers would start digging in Hong Kong, where the Chinese Communist Party may have a lot of bodies buried, with (mainland) Chinese publicly traded companies. I guess that's where they drew the line in the sand.
So, shorting is becoming more challenging?
Definitely. We have had some interaction with the Ministry of State Security in China that has actually been painful. Nobody has been tortured in our team, although it has happened to investigators who worked for others. I can't go into details, but there has been harassment of people and their family members, and that's created issues for Muddy Waters. If you want to go after Focus Media, you do so under the possible penalty of being accused of delving into state secrets. We are done with companies that operate in China.
Is that why you picked on Olam International in Singapore?
An investor [in Hong Kong] said: 'Hey, you need look at Olam.' He told us about all of the accounting restatements and the fact that it operates in Africa. Who can really do an audit that its business is actually what it claims it is? We didn't come back to Olam until July this year. That was around the time when Olam's chief financial officer, Ravi Kumar, resigned. So, when we looked again, the company had burnt more cash, raised more money and burnt more cash.
So, that's when we started gathering financial statements, looking at Nigeria and assets like Crown Flour Mill. We realised that the flour mill wasn't the acquisition the company had claimed it was. We kept digging and, fairly early on, we figured there was a clear pattern: Olam acquired businesses that had large top lines, but weren't really profitable.
Did you go to Africa yourself or did you send someone there to investigate?
Some of our team members were in Africa, but most of the work there was done by investigators we had hired.
Talk about yourself. You are a one-man research band, but you work with others with whom you share short-selling spoils?
Look, I know that I am often labelled a one-man band. But that's not true. [Our set-up is such] that I am the only publicly known person in Muddy Waters, but we have a real team. Most have their own businesses or day jobs and what they do for us is a side job. It's a very loose organisation.
You claim you don't actually sell your research. But your website mentions 'clients'. Oasis Management LLC in Hong Kong has been a partner of yours. How does this research relationship work?
I am not going to comment on specific companies or people. Basically, we pool our money. Everybody who is aware of the report participates in the research process. The main economics in Muddy Waters is the profits that come from the investments. Everybody has his own capital at risk. So, all the stories of our calling hedge funds or selling reports or telling hedge funds about an incoming report are really nonsensical. Why would we do that if we have our own money at stake?
Let me ask this straight: Are you colluding with hedge funds to profit from short positions in companies like Olam?
No. As I explained, the only people who are investing and taking positions with us are those involved in Muddy Waters. I do meet with other hedge funds all the time. Sometimes, we may get an idea from what we discussed with a hedge fund. Sometimes, we may share ideas. But we are not investing with them and they are not investing with us.
On Nov 1, you showed up at Olam in jeans and a baseball cap and gave a fictitious name. Why not say upfront that you are Carson Block, a potential investor?
Look, I am not going to comment on any specific incident. In general, I want to speak with management, but management is never going to speak with me. We put in a lot of time and resources into these research projects, and sometimes, openly speaking to management can jeopardise the whole project. After the report is published, the company can always say, 'Of course, we would have been happy to speak with him,' but we all know that doesn't happen in the real world.
Several hours after I spoke in London, [Olam CEO Sunny] Verghese said he wished I had asked him the questions I was raising. Later, he admitted that I had indeed asked questions, but said I had a baseball cap on. The real problem is that I had criticised his company. This stuff about my sneaking into his office or that I wore a baseball cap is just designed to deflect the real issues.
What is your case against Olam as it stands right now?
The fundamental problem with Olam is that it has borrowed huge sums of money and invested in projects that are not going to be able to generate the cash to pay back that debt. We believe that its equity is worth zero as a result of this large debt load and its underperforming assets. There is also Olam's historical inability to account properly, which is alarming. One of the things that Olam constantly touts is its risk-management capabilities. But Olam is a company that has probably taken on too much risk. It seems like it has a large Level 3 derivatives book. If this company can't seem to do its accounts properly, we really don't believe that it is managing its risks properly.
Let me encapsulate that based on recent events. This company can't remember what happened just a few days earlier. On Friday, Nov 30, in multiple media outlets, the CEO was quoted as saying that the company won't be raising any money from debt markets for five or six months. On Monday, Dec 3, he said that it was the banks that brought the investment proposals to Temasek, which then brought them to Olam. On Tuesday, the company said: 'No, on Saturday morning, we brought the proposal to Temasek and the banks.' [Sighs.]
It can't seem to remember what happened a few days earlier nor can it tell us what might happen a few days later. When a company is this bad at remembering stuff and has such short-term memory lapses, I don't know if that is the sort of company that investors can trust with billions of dollars of their capital.
What went wrong at Olam?
It started out as an agricultural trading firm with an asset-light model, then began investing in upstream and production assets as well as midstream and downstream such as processing and distribution. Back in 2005 or 2006, Olam was a good, little business. It was a medium-sized company, had an interesting trading business, an interesting model, but these guys suddenly put the pedal to the metal and that's when it really messed up.
Olam's management has put up a fairly spirited defence in trying to answer your allegations. That's far better than Sino-Forest or other reverse takeover firms.
When we read its 45-page response, we thought it had actually started writing it before it even saw our report. It thought I had talked about biological gains, so it wrote about that. Its report was a non-substantive response. It only attempted to respond to one of the 70 or so restatements that we had questioned from its cash-flow statements. And its response was to admit that it made a mistake without explaining how or why. In one of its responses, it talked about negative goodwill, saying people ignore all the times when it had positive goodwill. In accounting, if you have a ton of positive-goodwill acquisitions and one negative-goodwill acquisition, you will still get the full benefit of the negative goodwill. They don't cancel each other out. So, it has really addressed nothing.
Olam has been very successful in raising capital and gaining investors' confidence for a number of years. The difference between it and a lot of much smaller companies that don't have good businesses and aren't able to balloon to size is that it has been much better at telling its stories. I was lucky to learn early in my career — because I grew up in the investing business — that when managers talk in buzzword-heavy language, it usually means there is really nothing there. The problem is that most of the analysts are usually too embarrassed to admit that they don't know what these guys are talking about.
You have described Olam's capital-raising exercise as a vindication of your thesis that it is just months away from collapse. Why would it fail when there is a sovereign wealth fund like Temasek backing it?
I believe this was a last-minute bailout. Our theory is that the banks went to Temasek, saying they were not comfortable lending to Olam anymore without some kind of backstop. Our theory is that the banks told Temasek: Either you guarantee that there will be some money to pay us back or we will stop lending and this firm will collapse.
Why would a big, reputable sovereign wealth fund like Temasek agree to something like that?
Obviously, there is the fate of its existing investment. But we think Temasek was looking at this issue as a sovereign rather than as just another investor. If you have a situation in which Olam collapses and banks have billions in losses and Singapore has big listed companies like Noble and Wilmar, investors and banks might deny them access to capital. In a worst-case scenario, you could be looking at a funding freeze for a whole lot of companies in Singapore. I think Temasek could have been worried about a systemic failure.
I also think Temasek is trying to protect Singaporean investors from a sudden crash of Olam. I can speculate that there might also be an element of Olam's being a national champion of Singapore and maybe it felt that there is some credibility at stake.
But, look, I don't believe that Temasek really thought it was a great idea to go invest more money in Olam at this point. I think its hands were forced by the banks. Unfortunately, its only choice was between bad and worse.
You have compared Olam with Enron, and everybody thinks that's a bit of a stretch. There is really no comparison here, or is there?
Enron was also marrying asset-light trading to asset-heavy production and distribution, although there is no processing involved in electricity. The other parallel is that the bigger the Enron trading business got, the more cash it chewed up. That's true of Olam as well. The most important comparison here is on non-cash accounting.
Early in our research, the similarity struck us, so I got in touch with Bethany McLean, the writer at Fortune magazine who first publicly exposed Enron. I asked her what she thought was the main reason behind Enron's collapse. She said: 'It was just a bad business model.' She said the single-biggest thing responsible for Enron's collapse was its accounting. It was constantly acquiring assets and booking gains in the present on those assets. It became addicted to this type of accounting, which was marked-to-market. The joke about Enron was that it was spending US$10 of real cash for US$5 of accounting profits. Something like that may be happening in Olam. The trap that Olam has fallen into is that it constantly needs to buy something to plug its earnings gap.
You say Olam is burning so much cash that it may have not much more than six to eight months left. How did you reach that conclusion?
Trying to figure out exactly what the cash flow or cash burn will be is extremely difficult in its business. You can look at analyst reports and there is no consistency in how the analysts project anything. But it has had negative cash flow in 21 out of 27 quarters that it has been public.
On capex, or capital expenditure, after I spoke in London, the CEO actually increased the capex spend. In theory, capex is something it can control. In reality, I don't think it can. I am also not sure all its capex is properly accounted for, so I question whether it can rein it in. It just needs to keep spending to hide the real nature of its problems. I think there is a lot more here than meets the eye. I know that this looks like a very sick business, though I don't know where the sickness is.
I believe that there are only two possible scenarios: either a collapse or an equity-raising in billions of dollar. Both will be positive for short-sellers like us. Equity-raising will be tremendously dilutive, and the stock will fall. But I don't think equity-raising is realistic, because it will require people with very deep pockets. You are not buying into much because the asset side of the balance sheet has serious problems.
What if it listed some of its assets in a business trust or did an asset sale to raise cash? Would that help assuage your concerns?
I am not sure how that would change things because, as I have been saying, it bought really poor-quality assets. Maybe there is some salvage value in its greenfield projects, but mostly, they are poorly planned and incompetently executed. If it was selling assets, I would be surprised there are buyers who are willing to pay as much as Olam paid for them. Of all the subsidiaries we looked at, there were only one or two that looked good to us, such as packaged food company Titanium Holding and its Nigerian subsidiary, OK Foods. But they are really small parts of the whole business.
Verghese says Olam will slow down, decelerate and recalibrate. Could that save the company?
Assuming that it stops most of the capex, yes, that will be very helpful. That could help put something like S$800 million or so in its pockets. The other thing it would have to do is pare back its trading business. It can exit trading in a few commodities where it does not have a competitive advantage and which takes up a lot of its capital.
If you keep giving it injections of cash, it can probably keep going for a while. Either the shares are going to be greatly diluted for it to survive a few years or the debts simply become astronomical. From our perspective, the worst-case scenario is that it becomes like the Chinese solar-cell companies. Their shares are down more than 90%, but the companies, which should have collapsed long ago, have been kept alive by the local governments' or the state banks' lending them more and more.
It seems that Olam's debt offering will put a squeeze on short-sellers like yourself. Will you give up or do you have the wherewithal to ride this out and keep hammering away relentlessly?
We are in uncharted territory now. I really can't tell you what our plans are. We are kind of taking this day by day at this point. But I am convinced that Olam will eventually fail. I don't know when that might happen, but I believe we will realise that target.
What do you make of all the equity research reports that say Olam's stock may double from its recent lows?
We have seen this movie before. It happened with Sino-Forest. Sell-side analysts are there not to be sceptical. They are there, in most parts, mainly to support investment-banking relationships. Some are very serious people who do their jobs diligently, and some don't. I don't know how bright the average sell-side analyst covering Olam is, but when I read some of the recent sell-side reports, I think they either did not read our report or chose to ignore what we wrote or are incapable of really understanding it. It's not a secret that sell-side research is often not intellectually the most honest, not to mention all the conflicts of interest.
What's next for Carson Block? Are you looking to set up a hedge fund?
At this point, there are no serious discussions about our becoming a hedge fund. We do have a passion for finding flawed companies and exposing them. I don't know whether you can marry that to a model where you are managing outside money. A hedge fund that is more likely to be successful is plain-vanilla long/short equities. And that's fine, but it takes away from what we really enjoy doing: finding companies like Sino Forest and exposing them. There are other companies in Asia and Singapore that we are looking into and will look into.
This story first appeared in The Edge Singapore weekly edition of Dec 10-16, 2012.