Harvest is an independant energy company with exploration programs in Oman, Indonesia & Gabon. While those projects may or may not pan out, Harvest has the vast majority of its existing capital tied up in a 32% stake of PetroDelta, a large Venezuelan oil producer currently pumping out over 31,000 barrels a day near the prolific Orinoco / Faja heavy oil belt (The Venezuelan government indirectly owns a majority 60% stake).

On March 6th of this year Harvest dropped a bombshell : A few days earlier it had entered into exclusive negotiations with a third party for the sale of Harvest’s entire stake in PetroDelta. The most recent audited, present value analysis of the proved plus probable oil reserves at PetroDelta puts the value at over $1.05 billion. Throw in the possible (3P) reserves – in the Orinoco belt possible oil reserves are almost always bankable – and you get an additional $860 million of value.

With approximately 37 and a half million shares outstanding (adjusted for a recent debt conversion) and the stock changing hands for $6 an change, something is clearly amiss. The market price is telling you that either (a) management is on the verge of selling PetroDelta at a price far far less than its intrinsic value, or (b) chances of any sale are slim to none given the Venezuelan’s propensity towards injuring its’ US-based oil investors.

It’s my belief that both risks are extremely overblown, and that a rational investor will rejoice at the opportunity to participate in the extreme upside / limited downside that currently exists in the common stock of HNR. In fact, if I’m right about this, Harvest’s stock could easily double in a short period of time as a possible sale moves forward. Here’s why :

The History of PetroDelta

The story of how this US-listed small-cap oil company got into bed with the Venezuelan national oil company PDVSA is a fascinating one and worth, for the uninitiated, reviewing . Harvest has been operating in Venezuela since 1992, when it signed a 20 year operating agreement with an affiliate of PDVSA to develop the Uracoa, Tucupita and Bombal fields. These three Orinoco belt fields were developed from 1937 through 1962 and abandoned in 1987 (when oil prices averaged $17.75 a barrel). Harvest’s pitch to the Venezuelans – let us come in with American technology and know how, and get the cost of the production down and throughout up such that the fields could be produced at a profit. The pitch was persuasive; or else at an average crude price of $19.25 ($31 in inflation adjusted dollars) that year there wasn’t much competition. Either way, Harvest ended up becoming the first American company since 1976 to be granted an oil field development contract in Venezuela.

The agreement called for the Venezuelan government to maintain full ownership of all hydrocarbons in the fields, as well as the equipment and capital infrastructure. Harvest received an operating fee for each barrel of crude oil delivered, as well as getting reimbursed for most of its capital expenditures.

Things worked well for a decade. When oil prices jumped 50% from 2002 – 2004 (going from an average of $22.81 to $37.66) Harvest’s stock price jumped from around $4 to over $15 as oil production from these once-barren fields gushed to 28,000 barrels a day. But with the rise to power of Hugo Chavez the good times were about to end.

In early 2005, PDVSA began to disapprove of Harvest’s capital budgets (PDVSA approval was a necessary component for all foreign operators in Venezuela looking to recoup their expenditures exclusive of the operating fee). At first this was odd to Harvest given the success they had in increasing production. Without certainty on what to spend in drilling new wells, Harvest’s production naturally declined over the year to 22,000 barrels a day.

It seemed very odd that the Venezuelans would want to throw a moneky wrench into production that generated substantial revenues for the government. But within months, it became perfectly clear what Chavez was up to – namely to nationalize the industry and whack the ‘obscene’ (in Socialist-speak) profits being generated by American gringos.

PDVSA proposed that, in place of the existing operating agreement, the three fields would be placed into a joint operating company (“JV”) to be owned 60% by PDVSA. Harvest would need to completely waive its operating fee, and instead be compensated through dividends declared by the JV. Along with bumping up the local income taxes from 34% to 50% (applied retroactively for a number of years!) the net effect was to steal a significant percentage of the net present value of the Uracoa, Tucupita and Bombal fields in the name of the Venezuelan people.

Under threats to have all three fields taken away unilaterally, Harvest attempted to hammer out an operating agreement for the new JV (ultimately named PetroDelta) while in a parallel action threatening to litigate the ‘theft’ of its existing license in international court. Harvest spent much of 2005 & 2006 threatening such litigation while hammering out an improvement to the structure of PetroDelta that would partially compensate Harvest for its losses in the nationalization.

Harvest wasn’t the only company effected by this nationalization attempt. Eighteen other international oil companies operating in Venezuela were given the same ultimatum. Exxon and Conoco balked at the terms, sued in international court (Exxon alone demanded $12 billion; after a 5 year legal slugfest they were recently awarded a paltry $255m, retroactively validating the decision by the management of Harvest to negotiate a better JV agreement in the first place) while the rest knuckled under and signed new agreements converting old operating service agreements to new majority PDVSA-owned mixed operating JVs.

After an extended set of negotiations, which included the intervention of the Venezuelan ambassador to the United States, the Venezuelan Ministry of Energy and Petroleum (“MEP”) offered up a sweetener to Harvest in exchange for voluntarily agreeing to contribute its rights to operate the three fields to the newly-formed PetroDelta. MEP agreed to transfer to PetroDelta the exclusive rights to three new oil fields, the Isleño, Temblador and El Salto fields (A link to a useful map of the fields can be found here). These new fields were located in the same geographic area as the first three and seem to share the same geology and productive formations. Also like the first three, Isleño, Temblador and El Salto had undergone minimal development in the past and would require Harvest’s expertise to develop a drilling program suitable for its’ particular geology.

In September 2007 Harvest and Venezuelan government signed all the necessary agreements and PetroDelta came into being. So in short, while Harvest gave up a lucrative cash flow business from operating its existing 3 fields, the company played ball with the nationalist crowd in Venezuela and picked up a 32% interest in 3 additional fields for its trouble.

PetroDelta ended 2007 producing 13,100/bopd due to the lack of capital investment over the prior two years. With Harvest back in charge and on the ground agressively drilling new wells, production steadily increased to 20,000/bopd in 2008. More importantly, Harvest drilled its first two wells in the Temblador Field (one of the three additional fields granted to PetroDelta) and both initially produced (“IP”) in excess of 2,000 bopd. Clearly Harvest had chosen its new fields well.

With the increase in production, relations with PDVSA improved. The Board of PetroDelta began declaring dividends of its’ excess cash (there was enough profit at existing oil prices for PetroDelta to internally fund its drilling program with excess cash flow) and by 2010 production inched up to 24,000 bopd while the Proved reserves (“P1″)  net to Harvest in Venezuela increased to 50.0 MMBOE and Probable reserves (“P2″) climbed to 103.6 MMBOE. On a net present value pre-tax, proved plus probable reserves had an audited value (discounted at 10%) of over $2.3 billion dollars.

In 2011 production at PetroDelta continued to improve; however relations with PDVSA turned cold. In April the Venezuelan government approved a new round of ‘windfall’ taxes. The tax on revenue was pegged to the price of oil, and called for companies operating in Venezuela to hand over 80% of revenue above$70/bbl, 90% when prices rise above $90, and 95% above $100/bbl. This confiscatory policy had the effect pitching the excess acash flow necessary to both pay dividends and fund a robust drilling program. Opting for the latter, PDVSA declined to pay Harvest its’ share of previously stated dividends and diverted what cash it could to a 2-drilling rig program with 2 more coming on in late 2011.  In spite of the financial difficulties, the fields continue to outperform, and both Temblador and El Salto saw new wells IP at approx. 3,200 BOPD; these were the highest IP rates recorded by Harvest since the beginning of the 2008 drilling program. But without access to its profits, Harvest shares tumbled, eventually bottoming out at $6 and change in Dec ’11 / Jan ’12.

Throughout the Chavez-induced difficulties Harvest has gone through, there has been a number of opportunistic buyers that approached the company regarding a bid for PetroDelta. Management has stated numerous times that the PetroDelta asset has significant value and would not be sold in a “fire-side” sale. These comments were not made without good reason; according to one source of mine, some time last year a Canadian firm made an informal offer in the mid-200 million dollar range for the asset only to be rebuffed by management without further discussion.

Harvest’s Other Assets

PetroDelta is the crown jewel of Harvest, but it does own a slate of international development projects. In the last 12 months Harvest has turned up disappointing drilling results in Oman and Indonesia. However, Harvest does own a 66.667% of an offshore block in Gabon, called the Dussafu PSC. The Dussafu is located in a few hundred feet of water, and is South East of the well known Etame field, operated with much success by Little Bear favorite Vaalco Energy (NYSE: EGY).

Appraisal well activity, completed in 2011, has shown positive results. To date Harvest has made three oil discoveries in the block, totalling an estimated (gross unrisked) 26 million barrels of oil. While nowhere near the opportunity of other off-shore African finds, this block does has significant value. Pritchard E&P analyst John Abbott, whom I think does the best work on this name, pegged the value of the Dussafu PSC at $3/share. Given that the structures of the three finds are direct analogues to the existing Vaalco Etame production its a good bet that value exists.

Harvest recently sold a large portfolio of US assets and paid down virtually all its’ debt with the proceeds. After doing so Harvest has approximately $1.50/share in cash, after adjusting for ongoing overhead and existing payables.

Who Would Want to Buy INTO Venezuelan Oil?

The market is clearly skeptical that Harvest could find a buyer with the necessary patience, never mind deep pockets, to take a 9 figure gamble on buying a minority stake in a Venezuelan oil company in the grips of Chavez’ socialist-stealing hoodlums. Under normal circumstances, no large cap oil company would throw its shareholder’s wealth at such a gamble. But there is one set of buyers eager to do business with Chavez : the Chinese.

Pushed into locking up oil supplies worldwide to feed a domestic demand for crude that has already topped 10 million barrels a day, China has spent a good part of the last decade investing large sums of money abroad in emerging oil fields. China’s strategy can be summed up rather simply – find cash poor, resource rich countries on the outs with the West, preferably those with autocratic govenments, and offer cash on the barrel in exchange for long term supply agreements. China agrees to turn a blind eye to any human rights ‘issues’, couldn’t care less how onerous the socialist tax regime is, and doesn’t worry about any anti-bribery niceties such as the US’ Foreign Corrupt Practices Act. The number one goal is to secure long term access to oil, preferably in places that the West can’t interfere with.

China has pulled off its oil land grab with remarkable success. The results have been most spectacular in five countries where Chinese state-owned firms deployed the majority of their cash : Sudan, Kazakhstan, Angola, Iran, and of course, Venezuela. (A full review of the Chinese invstment in the overseas energy industry is beyond the scope of this article. If the reader is interested in exploring this admittedly fascinating subject, the easiest and best way to go about it is to read this 52 page report by the IEA written in February of last year.)

In the past two years, Chinese state-owned companies have signed in excess of $14 billion in various development and long-term purchasing deals with PDVSA affiliated entities. It’s not as if the Venezuelans had much of a choice; the existing operators are loathe to commit additional capital to a country that steals, uh, taxes 80-90% of your revenue. Without new investment, existing wells mature and decline, and as such overall production has been declining over the past few years to where current output is around 2 million barrels a day. For a country estimated to possess anywhere from 100 billion to 900 billion barrels of oil this is nothing short of an embarrassment.

In my discussions with a number of industry contacts close to the situation both inside Venezuela and in the US, the two oil companies most frequently bandied about as being the likely acquiror for PetroDelta are Sinopec and CNOOC. Both oil companies are significantly state-owned and have invested tens of billions of dollars in securing oil deposits overseas. Just recently Sinopec agreed to invest billions to develop the Orinoco Junin 1 and Junin 8 blocks, which could each produce up to 200,000 barrels a day of crude. CNOOC has also been active, signing a number of joint venture agreements with PDVSA to develop various new fields within the Orinoco belt. At every turn, officials at PDVSA and both Chinese companies have made it clear that existing deals are only the beginning as all parties intend to work even more closely developing the multi-billion barrel opportunities that abound in the Orinoco.

What is PetroDelta REALLY Worth to the Chinese?

A number of analysts I spoke to who follow Harvest say that the convential wisdom amounst oil & gas investors is that Harvest could reap $200-$300 million in any sale. Most observors of Harvest get this number by looking solely at the 1P value – namely the proven oil reserves from wells already in production, and ignore everything else. Harvest has 38.6 million barrels of proven oil attributable to its share of PetroDelta and at $6-7 per barrel you get a 200-300 million dollar range. Even the bulls at this  point would be happy with such proceeds, as the entire market capitalization of Harvest is under $300 million – and that’s before adding in the value of Gabon and existing cash reserves.

I think its highly unlikely management would go through the legnthy process of selling an asset it has developed over 20 years for solely its 1P value. In fact, in a telling exchange I had with James Edmiston, CEO of Harvest, on the latest conference call March 15th, he said exactly that (a link to the transcript can be found here)

Zachary Prensky : I think what would be helpful, (…)

is to give us a little more color as to what metric

 you find the most compellinginternally as you strike your own

 valuation on the Petrodelta asset.What I mean is, (you said) there will

be no fire sale of the asset (….)  But as you define

a fireside sale, what is the single-most important metric

that you look at, at valuing it, and then comparing your own internal

valuation to what you would accept in the sale process?

James Edmiston : What I can point to, though, what I’m allowed to point to are

 things like the reserve report where the after-tax PV-10 in the reserve report this year

for the 2 PKs is a little over $1 billion for the one, a little over $1 billion.

So it’s a pretty big chunk of money.The other thing you can point to is just

classical metrics, I guess. I mean, in the last year I believe Steve pointed

 out we had $57.7 million in earnings from Petrodelta at the Petrodelta level.

So, you’d have to tell me what’s the appropriate multiple

 for a business that grew at 33%, that has a reserve-to-production

ratio of well in excess of 20 (…) to well in excess of 30 if you count the 2P…

So there’s a broad range of metrics you can throw at this thing and obviously

 we have our own internal view (…)

I’ll be honest with you, I don’t think anybody in our business is trading

 on a 1P metric in the first place I know the analysts like to use

1P, and they show it as a metric, but as a buyer and

 a seller of assets, I can’t — nobody does that.

 I think it’s clear from the above exchange that management would never have entered into exclusive negotiations to sell PetroDelta if it didn’t have a range of values closer to the $1.1 billion dollar after-tax PV10 reserve value. Of course they know that the onerous tax regime in Venezuela makes such reserves less valuable. The flip side to that is that the confiscatory tax policy have made it increasingly difficult for anyone without a side deal with Chavez to justify investing fresh capital into drilling wells and growing production. Chavez will not live forever, and if his well-publicised recurring bouts cancer take a turn for the worse then his abilities to steal oil revenue over the long term are limited. PV10 reserve valautions take into acccount a decade or more of production – its important to note that less than 10% of PetroDelta’s six fields have been developed. Put another way, there are thousands of potential low-risk drilling oppotunities to be developed in the coming decades at PetroDelta – fields like these are the ultimate in long lived assets. Its a virtual certainty that at some point in its’ development PetroDelta’s owners will be paying less in confiscatory taxes than it is now (and again, important to note, even with the existing taxes PetroDelta is fully funded in its existing, admittedly low, capital development plan).

My contacts I’ve reached out to say that James Edmiston would take a number around 50% of the PV-10, or a range of $450-$600 million. Before you laugh, remember that such a price tag gives zero value to the 3P, or possible reserves, currently pegged at over 100 millions barrels of oil. And one thing we know about the Orinoco is that possible reserves have a funny habit of becoming probable reserves (remember that at one point not to long ago all six fields were abandoned and thought to be non-commercially relevant)

In fact, you could make the argument that the Chinese have additional non-commercial reasons for locking down PetroDelta, namely to secure long term oil supplies, and they would be more inclined to pay a number closer to PV-10 just for the exclusive rights to buy the oil. But I don’t think you need to get there to come to the conclusion that the Chinese would gladly pay $500 million, 50% of PV-10, 25% of P3, in order to own this underdeveloped asset.

What Would a Sale of PetroDelta Look Like?

As I discussed earlier, Harvest needed to get its’ shareholders to approve the original deal with PDVSA that formed PetroDelta, and under any sale agreement would have to likewise proxy its shareholders for approval to sell the asset. Under its’ agreement with PDVSA (which you can read as part of Harvest’s 2006 proxy, located here. The relevant section is located on page 40) Harvest has the right to solicit offers for its’ ownership stake in PetroDelta. PDVSA has a 30-day right of first refusal, after which Harvest has 180 days to close the sale.

People have a long memory down in Venezuela, and I’m sure there’s more than a few people who remember how Harvest outmaneuvered PDVSA in getting the Isleño, Temblador and El Salto fields thrown into the  PetroDelta JV. I am assuming the socialists in power will want to let the door hit Harvest on the way out, and threatening behind the scenes to drag out any potential deal with the right of first refusal is the best way to go about it. You can be sure any sale will include the obligatory payoff to those in power, most likely by shaving off 10-20 million in the purchase price, with said funds finding there way back into the right pockets. But ultimately its all about dollars and cents; the Chinese have it in spades, and the Venezuelans don’t.

Both the Venezuelan government and PDVSA in particular have been perenially short of funds. Government bond yields are some of the highest in the world outside of Greece (although, interestingly enough, Venezuelan bond prices have recently rallied sharply- is the market sending a signal as to the results of the upcoming elections?). Chavez’s socialism has led to significant budget deficits which have been filled with more and more petrodollars being skimmed off the top of PDVSA and its’ local operators. In recent years the Chinese have offered to fill part of the funding gap by structuring loans-for-oil (again, more deeply discussed in the abovementioned IEA paper, see page 12 in particular). Again, my contacts have led me to believe that any deal to sell Harvest’s stake to a Chinese firm will come alongside additional capital injections into either PDVSA or PetroDelta itself using some variant of loans-for-oil. Some of the additional cash will most likely find its way into increasing the existing  4 rig development crew into a world class drilling plan more appropriate for a set of fields that can easily produce 40, 50 or 60 thousand barrels a day.

However the Chinese and the Venezuelans cut their deal, its clear they both need each other. And absent Chavez out and out stealing Harvest’s stake in PetroDelta, there’s not much to do except pay Harvest off. (One important note is that while Chavez has nationalized the oil industry, anyone who has gone along with the plan and agreed to operate under the rubric of a 60% PDVSA owned joint venture company has been allowed to continue unimpeaded. And why not? Between PDVSA’s cut and the windfall taxes the government ends up with the vast majority of the revenue. Why steal 100 cents when your oil ‘partners’ hand over 85 cents voluntarily?)

In short, if Harvest was going to sell out at the bottom, they would’ve taken one of the lowball offers pitched to them over the past two years. My best guess is that a deal will be worked out as a three way agreement, whereby PDVSA waives its rights of first refusal (Given how strapped they are by the windfall taxes, PDVSA has had difficulties in even paying its vendors) in exchange for the Chinese agreeing to either lend or invest cash to grow production and help PDVSA out with its’ bills. After all, if the Chinese are able to front a few billion dollars in what is essentially pre-paid oil deliveries why shouldn’t the Venzuelan government be pleased to have them as the new owners of Harvest’s minority stake in PetroDelta?

What If I’m Wrong?

Making a binary event bet is always fraught with risk. While my contacts on the ground are optimistic a sale goes through, there is no guarantee of any successful conclusion. In a situation like this, both the risk must be worth the reward and the downside must be limited. I believe both are true in this case.

On the upside equation, again I would refer the reader to John Abbot’s work on Harvest. (Pritchard Capital is a dedicated O&G shop, and in my experience has had a lot of success in covering these names. If you work at a hedge fund, trade and/or invest in the energy space, and don’t have a relationship with Pritchard you are doing yourself a disservice!) In his updated model published on March 19th he gets to approximately 50% of the $1 billion after tax PV-10 for the P1 and P2 reserves – or $15 a share before ascribing any value to the Gabon assets – and as I’ve described above that’s around where I expect management to be a willing seller.

On the downside, if a sale ultimately falls through its hard to see Harvest’s stock going much lower. Remember that Harvest will still own 32% of PetroDelta, and the fortunes of that investment can only improve if either Chavez’ cancer gets worse, or if the market perceives that he will lose the upcoming October 2012 elections. All the opposition parties have rallied around one candidate, former Governor Henrique Capriles Radonski. While I am no expert in Venezuelan politics, when Chavez-friendly outlets such as Pravda admit he may lose the election the race is tighter than it seems on the surface (Also worth noting that Chavez’s Anti-Semitic smears smack as a bit desperate given that Capriles is a highly noted, rosary-wearing Catholic, who headed straight to a Catholic shrine to give thanks after winning the Presidential primaries). And lastly, voters can’t be amused that Chavez seems to fly off to Cuba every other week for radiation treatments – not the best confidence in a leader you are electing to a new six year term.

So, in a way, Harvest is a low-cost option on the future of Chavez. Its clear from the out-of-control violence to the punishing inflation, Venezuela is a Latin America country falling apart with only the cult-of-personality that Chavez maintains keeping his socialistic vision in power. Like taxes, death is certain to end his reign. With PetroDelta self-funding itself in spite of the windfall taxes, and 90% of its’ acrage still undeveloped, the smart money says that its’ Orinoco oil will still be pumping long after Chavez’s heart isn’t. Therefore, I don’t see much downside from here – actually a case could be made that shareholders are better off if the sale falls apart in a few months if Chavez’s numbers in the polls continue to underwhelm.

Conclusion

As someone who focuses most of my time seeking out binary events where the payoff is skewed, I cannot find too many opportunities better than Harvest Natural Resources. I believe the recet weakness in the stock is due to (a) skepticism over Venezuelan politics allowing for a sale of the asset; (b) doubt over management’s resolve at not accepting a low-ball bid; (c) selling from recent holders of the convertible bonds (the company recently saw a $16m tranche of convertible debt exchanged for approx. 3,000,000 shares at $5.56/share, a low enough price to incentivize those sellers to hit the bid); (d) worries over a recent ATM shelf filing (which cannot be sold into the market currently due to the continuing blackout period surrounding the sale process) which, according to a contact of mine that spoke recently to the company, was put in place to give the company financial flexibility should the sale talks collapse.

None of the reasons, in my opinion, for the relative weakness in the stock price, are indicative of the relative merits of a sale of PetroDelta happening. In my mind, the inherent value of this asset is too great for all parties not to find a way forward. For a management team that has operated in Venezuela for over 20 years I simply cannot believe that they are taking a flyer on feeling out a lukewarm buyer. While I certainly do not know anything more than the market does, all my conversations with people heavily involved in the Venezuelan energy sector lead me to believe the talks are for real. And therefore, this is one special situation worth taking a bold gamble on.

At the time of publication of this research, I am long shares of Harvest Natural Resources, Inc. (“HNR”)

I quickly ran the numbers. It was possible that the pre-salt opportunity in Angola mirrored that of offshore Brazil, where finds like the Tupi field where Petrobras (NYSE: PBY) confirmed a multi-billion barrel potential find. Petrobras and others were committing themselves to spending tens of billions of dollars over the next decade to build out these offshore pre-salt fields in what has the potential down the road to rival the current production numbers emanating from the Persian Gulf.

Geologically, most scientists believe that Africa and South America were once connected, and separated over millions of years in a process knows as ‘continental drift’. If true, it is highly possible that the stratospheric finds in offshore Brazil would be ‘mirrored’ in similarly situated West African pre-salt deposits.

What made Cobalt’s stock continue to climb is that Maersk, owner of an adjacent Angolan block, hit big on its’ pre-salt appraisal well. When that news came out in early January, I bought a fairly large stake in Cobalt at around $15.50 and hoped for the best.

As the stock kept creeping up on me, I sold against my long position, first the 17.5 calls and then the 20 calls. Fairly quickly, I was up almost 30%. Wowzers, I told myself. Who knew investing in Angola oil could be so profitable, so quickly? By the time February rolled around, I was fully hedged and called away on my Cobalt stock at $20/share.

What seemed to be such a smart investment turned into a disaster, as I watched Cobalt last Friday announce a mammoth,  1,180 foot “gross continuous oil column” in its Block 21 Cameia-1 appraisal well. The stock closed the night before at $23.90 and promptly opened the next day at $33.98. I watched in horror as all my homework on Cobalt was realized, staring at me on my screen, except I wasn’t participating in the profits one iota. I left the equivalent of a years’ worth of profit pass by without me because I was too myopic in taking the quick money.

Fast forward to this week. I’ve reviewed in depth the maps encompassing the Kwanza Basin, which is the area offshore Angola that both Maersk & Cobalt hit their respective pre-salt targets. Most of the offshore blocks are controlled by large international oil companies such as Conoco Phillips (NYSE: COP) and Total. However,93 miles north from the Cobalt discovery and within the Kwanza basin, sits block 5, owned by a small, well run outfit called Vaalco Energy (NYSE: EGY).

Vaalco was founded in 1985 and brought its first offshore well online in 1992. It began development in Gabon in 1995 with the Etame field permit and started production in 2002. Since then, its daily production, currently running around 4,000 barrels and solidly in the black, has come mainly from its Gabon assets. With cash as of September 2011 of $112m and net property/equipment of $102m, EGY (with 57 million shares outstanding and trading around $7/sh) has more than half its’ value in cash and tangible assets. Throw in the value of its Etame and other Gabon fields, (Vaalco has 7m barrels of proved reserves and plenty more in the probable column) and the current stock price is attractive on the basis of those items alone. But the real kicker that could propel this stock forward in a meaningful way comes from its 40% ownership of Angolan Block 5.

Block 5 is operated by Vaalco and is made up of 5,700 km or 1.4 million acres of offshore drilling opportunities. 12 wells were drilled by prior operators, and 5 of them reported oil and/or oil shows. Two seismic runs were performed, one in 1997 and another in 2008 (both 3D surveys comprising over 1700 sq km) and a number of promising prospects were identified. Of those, one stands out the most : The Loengo Prospect.

Loengo sits at the southern end of the block, is situated in 510′ feet of water, and has an exciting pre-salt prospect. The company estimates a well would cost $35m to drill the 11,000 feet to the pre-salt formation. Over the past year and a half it has struggled to identify a new partner (Norweigen Interoil walked away from its’ 40% stake around 2 years ago) with which to split the drilling costs. Although there are multiple prospects throughout the mammoth 1.4 million acre field, to date no one has stepped forward. But all that has changed now that Cobalt announced the results of Cameia-1.

Industry players I reached out to told me that since Block 5 lies within the Kwanza basin, Vaalco should have little trouble finding a major oil company to step into Interoil’s shoes. I spoke with Vaalco’s CFO, Gregory Hullinger, last night, who reviewed the numbers with me. Drilling costs are estimated at around $35 million, and any new partner would have to pick up a few million of accrued costs as well as a permit/transfer fee to Sonangol (The Angola state oil company, which holds a 20% carried interest in the block) that could range from 3-5 million dollars to something approaching 10-12 million. (Offshore Angolan blocks have jumped in demand overall since the Cameia-1 results with the Angolan government being the immediate beneficiaries.)

Mr. Hullinger confirmed to me that, in concert with what I’ve heard from others, his phone has been “ringing off the hook”. From what I’ve gathered, its probably a 2-5 month process to weed through the inquiries and nail down the terms for bringing on board a new partner. Vaalco has established a data room and put Sonangol on notice that it intends to move forward expeditiously. In fact, it seemed to me after my phone call that a potential hiccup in moving forward would lay with Sonangol not moving fast enough for Vaalco and its’ new partner in approving the deal.

Stephan Berman, an analyst at Pritchard Capital, has, from my vantage point, done the best research on this company (If you are in the hedge fund world and don’t do business with Pritchard you are missing out on some great oil calls).  He downgraded the stock sometime last year due to what he described to me as his “frustration” with the pace of Block 5 development. That is clearly about to change. Even without the excitment surrounding Block 5, Berman has an $8 target on the stock. The potential for Loengo could be anywhere from 10-50 million barrels of oil, and for a company with less than 10 million proven barrels under reserve, this is clearly a game changer for shareholders. As for the entire block, Sonangol themselves estimated that there is a potential 350 million barrels of retrievable oil, and again, that was before Cameia-1.

I’d expect Pritchard and others to pick up the pace of coverage and start highlighting the value inherent in Vaalco over the next few weeks.  The company will report earnings on March 12th and host a conference call on the 13th. Expect management to ‘bang the table’ with regards to Block 5 and highlight its increased value. I also wouldn’t rule out strategic talks with other players. Its an open secret that Vaalco has  evaluated potential mergers in the past year. Vaalco is an offshore driller with a $400 million market cap and its’ really too small over the long haul to continue to build up drilling opportunities without taking risks too large for any one dry hole to sink the company – if it had to fund Loengo by itself it would cost 25% of Vaalco’s cash position. I wouldn’t be surprised based upon the potential size of Loengo and other Block 5 prospects for these talks to turn to an outright sale of Vaalco.

At the current price of $7 and change the value here is too significant to ignore. I’m a buyer of the stock right here, right now, with what I see as a $1 and change of downside. If the Angola pre-salt opportunities continue to develop as the Cameia-1 has, with literally billions of barrels in extractable oil, this slice of West Africa may very well turn out to be the next Persian Gulf (as the decade long built out of Brazilian fields such as the Tupi discovery are rapidly turning out to be). If that is the case, small Vaalco would certainly be in play.

The bottom line here is that Cobalt Energy tacked on over 8 billion in market cap due to the overwhelming success of its Angola drilling to date. At a market cap 1/30th the size of Cobalt, Vaalco’s stock has a long ways to go if Loengo is successful. Over the past few trading days Vaalco has gone from $6 to $7. This train is leaving the station – count me on board.

At the time of publication of this report, I am long Vaalco Energy common stock

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This time around, investors demanded cleaner, easier to follow, publically traded vehicles and Wall Street responded with such plays as Sandridge Permian Trust (NYSE: PER) or Chesapeake Granite Washington Trust (Nasdaq: CHKR), two vehicles where the rules and risks are stacked heavily in the investor’s favor.

Much like the O&G partnership collapse, speculating in Chinese equities almost came to a complete halt earlier last year with the string of collapses that took place within mere months of each other of well known and widely owned stocks.

RINO International. China MediaExpress. China-Biotics. Longtop Financial. It wasn’t too long ago that these names dominated headlines. It was just last April that the New York Times published its front page business section piece entitled “The Audacity of Chinese Frauds”, detailing the absurd lengths Longtop’s management had gone to interfere with Deloitte’s audit of the company’s cash on hand. 

Yet, implausibly enough, in the case of the feverish buyers in Qihoo 360 Technology Co. Ltd. (Nasdaq: QIHU) they have only let a handful of months pass from when the height of the Chinese frauds hit the fan to when these self-styled momentum investors collectively hit the buy button on a multi-billion dollar Chinese internet stock trading at 10 times trailing revenue.

I find the whole shebang extremely fascinating for the following reason. Qihoo is a classic ‘battleground’ stock. To it’s supporters, Qihoo has revolutionised the Internet market in China by using its free anti-virus software to help it catch hundreds of millions of page views per month in ‘home page’ or ‘web-directory’ traffic.  Qihoo describes itself as the 3rd largest Chinese internet company, with a customer base of over 300 million users.

The bears on Qihoo, led by veteran short seller Citron Research, has pointed out numerous holes in the firm’s financials, business model and market share. In a followup, detailed piece published in early December, Citron Research calls Qihoo and out-and-out fraud.

A more recent addition to the debate is Deloitte-Watch, a website apparently devoted to tracking the shadier side of Deloitte’s Chinese auditing arm. It was most likely DW that pushed Deloitte to go the extra distance on auditing Longtop Financial last year, a level of scrutiny that ultimately pushed that fraud into the spotlight with antics described so deliciously in the above-referenced NY Times article.

These types of ‘battleground’ stocks are not unique to China and there are literally dozens of plays at any given time where in-depth research on highly controversial names can bring out the winning side. As an investor and trader one can try to pick apart each competing side’s claim and take a stand on the issue. However, it’s not my intent today to wade through the various claims and counter-claims of each side.

What I do find fascinating in this particular case is the relative odds implied by the current market price of Qihoo’s common stock. Usually, in a battleground name where each side has strong arguments, the stock price in question implies a 30%,40% or 50% of success for each side coming away victorious.  A good example of this is tonight’s Amazon.com earnings release. Speak to the analysts and you’ll come away with the arguments for either a $1b+ topline beat leading to a 10-20 point blowout to the upside, or else a major miss on the operating margins and earnings which would probably get the stock down 15-25 points. Pull up the option chain and you’ll discover highly pumped price tags all up and down the strikes. Bottom line, the options are pricing in a near 50/50 for each side in this battleground earnings play.

Qihoo is different. Given its 10x revenue valuation, hundreds of millions of dollars of insider stock holdings that are now available for sale, and the recent speed bump most Chinese ecommerce names have hit, you’d expect this name to trade somewhere between the $5 price tag the bears have put on it, and the $2-$2.5b valuation that even the most optimistic bulls can get to on a discounted future cash flow analysis.

Yet the stock sits today at $17 and change. With 122 million shares outstanding on a full-diluted basis, ‘Mr. Market’ has apparently decided that the bear case on Qihoo has little to no chance of bearing fruit. (am I the only one who finds it interesting that Qihoo hides the fully diluted count in its cash flow per ADS statement in the company’s earnings release? You can calculate it by dividing the net income by the Diluted earnings per ADS) This, despite the fact that Citron Research has a 10 year track record of uncovering corporate fraud. This, despite the fact that DW’s work on China MediaExpress and Longtop literally changed the outcome of those two corporate audits.

It seems to me that the investor base in Qihoo have all-too quickly forgotten recent history. DW claims it is in possession of a whistle blower interview that, if true, would blow the doors off Qihoo’s legitimacy wide open. Consider this description of these insider allegations:

• Deloitte-Watch has obtained a copy of a detailed interview with an individual associated with Qihoo 360′s sales department who states that the company is inflating revenues by over 40%, and has detailed the existence of “ghost links”on the hao.360.cn web page…
• The interviewee states that Qihoo 360′s homepage traffic peaked some time ago and now is actually falling. ..
• For safety and security of this person, the identity of the interviewee cannot be publicly disclosed. But, a copy of the interview has been sent to your legal department.

Think to yourself for a moment. Is it possible that DW is completely making this up out of whole cloth? More importantly, What are the odds that this whistleblower actually exists?

If Qihoo were any ordinary ‘battleground’ name, this stock would trading somewhere in the midpoint between the two sides. Gun to my head, I’d guess $10,11 or $12 a share. Its an absolute shock to me that with all the accusations flying on this name that the sum total of market participants are giving Qihoo a $2b+ valuation.

Investors have forgotten that China MediaExpress had its’ stock halted when it was $11. Longtop’s final trade before the plug was pulled by Deloitte’s aborted audit was $18.93 a share implying a $1.1 billion market cap (last trade I could find : 8 cents). It wouldn’t shock me if Qihoo collapsed in the same, shocking fashion.

I’m not implying that Qihoo is or isn’t a fraud, although for the record the bulls I’ve spoken to have never confirmed to me their revenue model, or that they’ve even confirmed that customers actually pay the 200 to 250K RMB a month Qihoo’s management claims is the going rate for a top level link.

What I am pointing out is that, unlike virtually all the ‘battleground’ stocks I track, Qihoo is giving the shorts a golden opportunity to enter the trade-  if you believe the thesis. Its been a long time since I’ve seen a ‘battleground’ name involving  top-tier shorts trade at a price that practically begs you to do the homework and enter the trade.

Skepticism is the currency of a trader who can survive a twisted tape. Qihoo is a very difficult stock to borrow, and trading in size makes it hard to get in and out of positions easily. I’ve spoken to all the major players in the names I could identify, and it seems to this trader that its’ the bulls who ought to be skeptical of management’s claims. But I respect the fact that my confidence threshold can’t possibly approach that of traders who’ve invested months and tens of thousands of dollars researching this name.

What I can add to the debate is the price and sentiment. Its about as bad a time to be a Chinese bear as I’ve seen in the past 6 quarters. Anyone I’ve spoken to outside of the committed Qihoo bears have no patience anymore for high borrow fees, illiquid options and a stock that trades as random as these names get.

But Wall Street desk skepticism doesn’t change the facts on the ground. And the facts on the ground in this case are that serious questions have been raised about the legitimacy of Qihoo’s operations and financials. And the fact is,  if even a fraction of these questions cannot be adequately answered, Qihoo’s stock is going lower, much lower.

As a contrarian by nature, I embrace the trade where I can stack the odds highly in my side’s favor. It may be  a hard trade, it may be one where the exact endpoint isn’t quite known – Qihoo needs to file its yearly financials sometime around April I believe – but its one where the desk jockey’s exhaustion with Chinese frauds works heavily in your favor. While Qihoo’s shareholders are currently in ‘see-no-evil, hear-no-evil’ mode, that type of smooth sailing for Chinese stock  cannot last forever.

I never made big money by being the last one into a trade. I think I’m early here but on the right side of the facts, and most importantly, sentiment. And the fact is, as Qihoo approaches its audit, you can be sure that the pressure will be on Deloitte to get the job done right. At a certain point before then, although I don’t know exactly when, the market will stand up and take notice of the risks inherent in passing or failing the audit.

And I strongly doubt when that time comes this stock will be anywhere near $17.

At the time of this article the author was short Qihoo

Sonosite is interesting because they are the market leader in the portable ultrasound market. Under chief exec Kevin Goodwin, Sonosite took the technology to miniaturize ultrasound from a niche experimental product line to a widely accepted portable platform rapidly gaining market share throughout the medical system.

Portable ultrasound is the fastest growing submarket within ultrasound, which in and of itself is a growing field. We have spoken to a number of physicians, and its very clear why. Over the past few years, using portable ultrasound has become the standard of care for a number of common hospital procedures. At one ER I spoke to, it is now standard of care every time PIC line in put into a patient. Another site usestol Sonosite to confirm the death of all bodies brought into the morgue. The number of one usage in an urban ER we spoke to is ruling out an ectopic pregnancy for patients presenting with vaginal bleeding – something that could take 3-4 hours waiting for anoverworked radialogy department to do the same thing.

Like many pieces of portable technology, once it gets introduced into an environment people discover new and more cost-effective ways to treat existing problems.  Its no wonder that, even throughout the sluggish economic malaise infecting North America, Sonosite was able to rack up a 24% increase in its core home market.

Perhaps the most exciting long term growth trend facing Sonosite lies within emerging markets. Its clear to me that in countries such as China and Vietnam, more medical services will be provided in small clinical settings scattered throughout the populace than in large centrally designated ones, making a great opportunity for low-cost, high value added product lines such as Sonosite. The company has a good presence overseas, with dozens of distributors in virtually every major overseas market. Unlike the US, their brand presence and awareness is less of a strength. In recent quarters Sonosite has had difficulty in generating the same growth overseas that they have in the US.  Therein, however, lies the long term opportunity for a strategic buyer.

Samsung clearly fits the bill. With operating cash flow approaching US$15 billion, Samsung earlier this year announced its long term investment strategy of  building a large medical instrument and technology business.  Taking a page from General Electric, Samsung’s  Lee Kun-hee sees the company’s future in investing its impressive electronics and shipbuilding profits into higher-margin businesses. You can’t find a larger target than medical devices.

Last year Samsung made its first major foray into ultrasound by acquiring a large minority stake in Medison, the world’s sixth largest manufacturer.  Samsung bought out most of the remainder this year and renamed the company Samsung Medison. While the purchase price was not completely disclosed, our estimates based upon various trade publications is that Samsung paid approx. 3x revenues, or nearly $600m for this approx. $200m business.

It’s clear to all Samsung observers that this purchase was merely a platform upon which to build a multi-billion dollar medical device business.   Jay Caplan wrote a good piece on this back in January. Since picking up Medison, Samsung has gobbled up a dental-equipment manufacturer and, just recently, a well regarded cardiac point-of-care testing solutions business.

Samsung has hired Morgan Stanley to identify additional candidates to acquire and according to press accounts has been spending a considerable amount of time  kicking the tires at Sonosite. A first round of bidding turned up Samsung and a handful of other unannounced players. My guess is that Roper Industries, Inc.  and possibly J&J were two of the interested parties.

I have had a few discussions with Sonosite distributors and my sense from them is that Samsung is the most logical buyer for Sonosite. Further, the feeling was that management of Sonosite is very predisposed to handing the ball off, so to speak, to the Koreans, which is important given the companies unyielding commitment to its’ customer base. No one I spoke to felt that Sonosite would not want to sell themselves at this stage of the company’s growth cycle.

Unlike many other medical device companies whose Boards of Directors maul their shareholders with ill timed and  highly dilutive offerings, Sonosite seems to have done quite alright by its’ owners. In July 2007 the company raised $225 million in convertible debt struck at $38.20 (the stock at the time traded between $27 & $32 per share).  As part of the deal the company bought 2.5 million call options at the convert price, hedging 42% of the dilution. These call options were partially financed with the sale of 2.5 million long-dated warrants at  $46.965 (effectively creating a bullish call spread). When Sonosite’s stock price declined, the Board authorized the repurchase of 1.4 million of those warrants at attractive prices, effectively lowering shareholder’s future dilution (and increasing the upside) above $47. Looking at these transactions, it’s clear to me the Board did everything in its power to lower dilution and preserve value for its shareholders in the eventuality of the sale of the company, which lends more credence to the Bloomberg story of an ongoing sales process.

Healthy medical device companies have historically sold for between 2.5x & 5.0x sales. Sonosite’s gross margins are in the mid to high 60s, a fairly healthy sign of its’ market position. Overall growth has been excellent and in my conversations with customers its clear that those who buy from Sonosite will continue to do so at a healthy clip. I don’t believe Samsung has any qualms with paying 3.0x multiple, especially since Sonosite has $200m of working capital (cash + A/R + inventory) in its most recent 10-Q. I also think Samsung has the most to gain from picking up Sonosite’s cross-license agreement with General Electric, the product of years of litigation that settled in 2009, an agreement which in my opinion was tilted heavily in Sonosite’s favor.

Although an article yesterday in the Financial Times quoted an unnamed banker as saying that fair value is around $50/share, my math gets me to between $55 and $60. I don’t think the Board of Directors would have been buying back $46.96 warrants if the game plan was to sell out at $50 – and the history of high growth/high margin M&A for businesses such as Sonosite bears this out. At today’s price of $41.50 I think there is $5-8 of downside if the sales process falls apart (a low likelihood in my mind) and $8 – $18 if Sonosite is sold. That’s a bet I’m more than eager to take.

Disclosure : I am Long Sonosite (SONO) common stock

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Late last night Harbin filed a curious 8-k detailing the settlement terms of the Nevada state class-action lawsuit seeking to enjoin Harbin from closing the buyout transaction with Abax and Tienfu Yang (Harbin’s Chairman and CEO). [The 8-k can be found here] This settlement was to be expected as the company had already dealt with lawsuits pending in New York State and Nevada Federal courts.

The details of the settlement include additional disclosure in an amendment to the proxy [Link to this amendment can be found here] being mailed to shareholders. As is typical with such settlements the plaintiff attourneys will have the right to be awarded fees and expenses once they’ve certified the class of shareholders they represent. While the filing doesn’t hint at the size of such award, in my experience it could range anywhere from a mid-six figure sum to a few million dollars. In general the more incentive the company in question has to settle, the higher the fee award they would agree to. Knowing that Harbin desperately wishes to pursue the pending $24 buyout it is safe to assume the amount would be on the higher rather than lower side.

With $87.5 million in cash plus an additional $17.5 million restricted as per the June 30th, 2011 10-Q  on the surface it would seem Harbin’s ability to pay such fees wouldn’t be in doubt. Yet, buried in the 8-k is an additional concession the plaintiff’s attourneys wrung out of Harbin – namely, lowering the breakup fee (from $22.5m to 19.75m) payable to Tienfu Yang (via his Tech Full vehicle) and Abax in the event Harbin Electric fails to close the buyout under certain circumstances.

This breakup was originally negotiated between the Harbin Special Committee and Tienfu/Abax. It works to Tienfu’s disadvantage to lower that amount. Why would the plaintiff attourney’s demand this as part of the settlement?

Usually during a pending acquisition a shareholder friendly group would look to lower the breakup fee payable to the acquirors because you want to incentivise other bidders to join the fray and consider raising the offer. That, to me, is obviously not the case with Harbin given the lack of interest from the dozens of acquirors previously contacted and Tienfu’s inability to work with any of them (documented oh-so nicely by Morgan Stanley’s report to the Special Committee [See the Link here for a gripping read!]  – my favorite gem, on page 9, is “On Multiple Occassions Mr. Yang stated directly to the special committee and to third-parties that he is unwilling to sell / relinquish control”)

If you dig deeper into Harbin’s cash position it becomes clear that the attourneys had good reason to fear be able to get paid in the event the $24 offer falls through. How so? Cash on hand plus restricted cash equals $105 million. But those funds are deposited with a bevy of Chinese banks that have also lent Harbin $36.9 million on short term revolvers, alongside an additional $36.8 million in short term notes outstanding. Net cash is therefore only $31.3 million of which more than have of that is restricted. Paying $22.5 million would be a stretch for Harbin and leave little left over for the possibly million dollar plus settlement to the attourneys. And what are the odds these Chinese banks would allow Harbin to operate at a net cash deficit? Lowering the number payable to Tienfu/Abax by $2.75 million, close to what I believe is the high estimate of legal fees payable, would give Harbin enough wiggle room to get both Tienfu and the attourneys paid in a timely fashion. (Of course that leaves nothing left for the $23 million down payment on the latest  land ‘purchase’ – all the more reason to believe that deal doesn’t get done either.)

One could argue that agreeing to lower the amount payable to himself is Tienfu’s way of showing his confidence in the $24 deal closing – after all, giving up something of nothing is an easy way to settle any lawsuit. But one has to wonder exactly what the plaintiff attourneys had in mind when demanding this change. As in any litigation, they have had most likely extensive conversations with Harbin and its’ counsel. If the plaintiff attourneys felt the chances of the $24 Harbin acquisition falling apart were negligable then why push to lower the breakup fee?

Harbin shareholders today have an opportunity to sell their stock at $21 and change. That’s not too far from the $24 takeout price and a long way above where this stock would be trading, in my opinion, if the acquisition does fall through. So again, I ask you this question – What do the plaintiff attourneys know about Harbin that the investing public does not?

Disclousure  : I am short Harbin Electric

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Reading the 8-k filing is like listening to a schoolboy come up with colorful excuses why he didn’t come to school with his homework – in short, it’s a Chinese version of the old hokum, ‘The Dog Ate My Homework’ (shout out to my dear friend who came up with that gem in a phone call with me last night!).

Buried in Harbin’s 10-Q filed in August was a disclosure that the company plunked down $23 million as a deposit for an 82.4 acre parcel in Xi’an. This land transaction was always highly suspicious – read my piece dated September 6th for the bear case. The down payment was made on the last day of the quarter, June 30th. The size was just enough of an outlay, coupled with additional CapEx expenditures and offset partially by continued borrowings on its’ short-term credit facilitates, to keep the quarter-ending cash balance close to what it was at year end 2010. This is important because if a company is reporting false profits it needs to shuffle the cash around somewhere. Since bank statements can be easily verified by auditors the best place to make fake cash disappear is within false or inflated asset purchases.

Investigative work by Alfred Little proved, through detailed interviews with officials at the Xi’an Lintong Tourism and Business Development Zone Management Commission, that Harbin never purchased the land in question. A second research firm, GeoTeam, corroborated the research Alfred Little did and confirmed that Harbin never closed on the land. If these findings are true, the 10-Q Harbin filed with the SEC was materially incorrect. If Harbin knew the land hadn’t been purchased when it filed the 10-Q, then the Company and its officers had committed fraud.

In a press release dated September 6th, Harbin purported to refute the findings by Alfred Little and reiterated that its financial statements concerning the land purchase were correct:

“Regarding the land purchase referenced in the report, the Company stands by the statements as disclosed in its 10-Q dated August 9, 2011. Harbin Electric confirms that the land purchase was done in full compliance with various relevant Chinese government entities and notes this transaction structure is a common practice in China.”

My strong suspicion is that in the past few weeks the SEC must have reached out to Harbin and asked it to corroborate its’ claim regarding the Xi’an land purchase. After all, Chinese RTO frauds have been all the rage and Harbin is currently in the process of getting a proxy statement through the SEC (in order to complete a $24 per share buyout offer). With those facts, you just know the Commission is taking a hard look at all the various allegations swirling around on the blogosphere.

So now Harbin does an about face and tells us in its 8-K filing that the land in question was never purchased after all :

“A prepayment of RMB150 million ($23.0 million) was made by the Company to Xi’an Lintong on June 30, 2011. The prepayment of RMB150 million previously made to Xi’an Lintong pursuant to the Investment Contract was returned to Xi’an Tech Full on August 24, 2011 in connection with Xi’an Tech Full’s execution of the replacement Project Agreement described below…..

On September 15, 2011, Xi’an Tech Full entered into a new Project Entrance Agreement (“Project Agreement”), with No. 2 Commerce Bureau of Xi’an Economic and Technology Development Zone Management Commission (“XETDZ”), a higher level government office, which superseded the Investment Contract, for the purposes of obtaining the use of a larger parcel of land.”

According to the 8-K the entire $23 million was returned to Harbin on August 24th. In other words, at that moment in time Harbin had walked away from purchasing the parcel. It only entered into a new agreement to purchase a larger parcel on September 15th. Yet on September 6th Harbin claims to stand by its statements in the 10-Q regarding the land purchase! Claiming the 10-Q is accurate while knowing full well the land purchase was cancelled two weeks prior is dishonest to the point that one has to question the complete integrity of management.

Clearly Harbin would argue, when faced with this line of reasoning, that the 10-Q was accurate at the time it was filed; however it is extremely misleading given the facts and circumstance to the point of being a a straight out lie.

The overwhelming odds favor Harbin making up this story about its deposit refunded (when was the last time you heard Communist apparatchniks return $23 million dollars voluntarily?) when it was called to explain itself to the SEC. Instead of faking a deed, I believe it concocted a story that allows to it to claim the 10-Q was accurate at the time it was filed. The lie would also allow the company to maintain the fiction that business is so great that the business needs to expand by buying an even larger parcel. And I should add that the new agreement provided for no downpayment, rather the first installment is due  October 15th – just enough time for the company to press the SEC to approve its pending proxy filing.

What the regulators ought to do – besides putting the proxy on ice – is subpoena all relevant documentation to corroborate the claims made in last night’s 8-K. That includes gathering evidence that the funds were returned from the Xi’an government to Harbin. That includes all the communication between the company and the government regarding the refund. And lastly, that includes discovering just what the company meant in its’ September 6th press release when it knew at the time it had never closed on its land purchase.

The overall stock market has undergone unprecedented volatility, mostly to the downside, all the while Harbin has made new highs. It’s clear to me, and most professional observers, that this company’s financials are materially misstated. Its time for the SEC to end this charade, halt the trading in the stock, and get some answers. Anything else would just be passively encouraging a fraud that gets more brazen with each EDGAR filing.

Disclosure : I am short Harbin Electric

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Interdigital (IDCC) is a patent holding company that put itself up for sale on July 18th of this year. Holding over 8,800 patents with thousands more applications awaiting approval, IDCC’s core strength revolves around the growing area of LTE/4G. While small, 4G is a growing share of the overall market and over the next 5 years is poised to overtake 3G as the dominant wireless standard. Expensive from a carrier perspective, consumers have shown a voracious appetite in using, and paying for, an increasing amount of data throughput. Carriers have increasingly discovered they can charge more as consumers accept the switch from all-you-can-eat data plans to those that cost more but provide a richer, more seamless service. So the question on the 4G/LTE front is not if but when the ‘tipping point’ occurs and 4G goes from being a minority segment to the dominating standard.

An investor deciding whether or not to be long IDCC stock needs to have some yardstick to value the company, and then compare the results to the current trading price to determine if taking the risk of being long IDCC is worth the eventual price. I would argue the best metric to value IDCC’s portfolio of IP would be to utilize a discounted cash flow analyst (DCF) – with the assumption that industry will eventually pay a set royalty rate per handset. Of course, charging and collecting are two different things entirely but to date IDCC has had success in getting the major handset manufacturers (Samsung & Apple) to pay royalties. Samsung’s agreement with IDCC runs out at the end of 2012 and Apple’s in 2014 at which point, assuming IDCC is still a standalone company, each would have to renegotiate payment terms (Apple currently does not have a 4G product on the market although it is widely rumored to be releasing one next year.  It currently pays royalties based upon IDCC’s older 2G & 3G patent portfolio).

The last comparable sale in the wireless patent space was the Nortel bankruptcy auction which yielded over $4b as Google went up against, and ultimately lost to, a consortium of wireless manufactures including Apple, Samsung & Research in Motion. The Nortel portfolio covered a wide range of over 6,000 patents and were mostly skewed towards existing 3G designs (114 were related to LTE, or Long Term Evolution, an acronym for 4G wireless technology).

Since LTE is an emerging market it’s extremely difficult to settle upon both the size and royalty rate that industry will support – necessary in order to generate an expected future cash flow. Multiple parties also own LTE patent portfolios, and therefore you need to come up with an estimated size of the overall LTE intellectual property and what IDCC’s percentage of it would reasonably allow it to collect in royalties.

The existing bidders for IDCC are most likely not buying IDCC for its current and future cash flow stream but rather to insulate themselves from future royalty payments – in essence prepaying (hopefully with a discount) future cash flows that would need to be paid to a standalone IDCC. This is why a consortium bid for IDCC is the most likely outcome, as multiple handset manufacturers’ could pool their future expected royalty payments and in theory, outbid any stand alone entity. Therefore, while an analysis of DCF is the best way in theory to gauge the value of IDCC in a sale, any consortium bidder would need a discount of its future payments in order for it to be worthwhile to ‘pay now’ (acquire IDCC) versus ‘paying later’ (litigating and settling down the road). One could argue that with global interest rates near zero that supposed discount is low, however, you could also argue that with corporations hoarding cash at record levels it requires a larger discount to incentivize corporations to pay upfront.

There is another value to an acquirer’s picking up IDCC; namely to make it difficult if not impossible for others to compete without paying punishing royalty rates – effectively neutralizing a future competitive threat. This was most likely the rationale between the bidding war between Google and the Apple-led consortium that lead to the $4b+ winning bid for Nortel.

So, to summarize, here is my cheat-sheet for analyzing the expected valuation of IDCC in the ongoing auction:

(a)    the size of the future 4G/LTE market
(b)    a reasonable percentage of the existing and future 4G/LTE IP held by IDCC
(c)    an expected discount to future payments a consortium bid would likely require
(d)    the value, if any, in utilizing IDCC’s portfolio to interfere with non-consortium manufacturers future products in making them financially non-competitive
(e)    a DCF analysis of the older, 2G & 3G portfolio
(f)    net cash position at closing

“Nuke John” an author on Seeking Alpha has penned what I believe to be the best published piece on DCF estimates for IDCC. While estimates vary, NJ makes a good case for assuming IDDC controls 20% of the 4G/LTE IP pie. I think a conservative estimate in market size is $75-100B in four years. Taking a 3% global royalty rate and assuming 20% market share gets you a $450m cash flow at the low end and $600m at the high end starting in year 4.

Now here’s the tricky part – what growth assumptions do you make for the cash flow, and when do you trail it off? To be conservative, I have modeled $450m in year 4 growing 5% a year stopping in year 11, and then decreasing by 50% for the next two years before going to zero. I have also modeled 150m a year for years 1-3 mirroring my expected value for the 2G & 3G portfolio.

DCF analyses require a discount rate on future cash flows. One could argue that in the current interest rate environment it should be between 5-6% but to be conservative I have modeled IDCC off an 8% valuation. The present value of the above cash flows at 8% equal $3.03 billion, which not coincidentally is not far from the current trading price of IDCC stock.

I throw in $530 million for the cash portion and assume zero value for the competitive disruption component of the portfolio and my NPV (net present value) of IDCC is $3.56 billion. At a fully diluted share count of approximately 46 million my DCF valuation gets me a price per share of $77.40.

Looking at the current stock price of $62, if I am right the market is primed to pay an IDCC investor a 25% rate of return for sitting in the stock through the conclusion of the auction. As a professional investor doing this for 15+ years that sounds about right to me given the risks inherent in owning IDCC. Another way to size up IDCC is to look at the call option prices and determine what odds the market is pricing in for my scenario. The October 65 calls are trading around $7. They would pay off $12.40 assuming a sale happens at my price and the market arbitrages the stock price without any financing risk (a good assumption in light of the current bidders for IDCC).

While I do not own a crystal ball I think you will agree there are a number of conservative assumptions baked into the above analysis. For one, I exclude any 4G/LTE payments outside of handsets (which is not what IDCC thinks its IP should command). Secondly 2G & 3G technology will be around for quite some time and it’s unreasonable to expect IDCC’s DCF to include only 3 years of payments for it. Lastly, the disruptive value of the IP is a wildcard that could easily push this auction past what a standard DCF analysis yields as fair value. Any one of these angles could add $10-$20 a share in a sale process with multiple bidders competing with each other.

Disclosure : I am Long Interdigital (IDCC) common stock

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NEW YORK–(BUSINESS WIRE)–Little Bear Investments LLC, (“Little Bear”) an owner of CIT Group, Inc. (“CIT”) (NYSE:CIT) debentures, approves of today’s release by the CIT Board of Directors and Steering Committee (collectively, the “Committee”) of the Offering Memorandum, Disclosure Statement and Solicitation of Acceptances of a Prepackaged Plan of Reorganization (the “Bond Exchange”). The Bond Exchange is designed to reduce the direct and indirect unsecured debt in CIT by approximately $5.7 billion. In order to accomplish this, the Bond Exchange offers certain bondholders the right to exchange existing unsecured bonds (“Old Notes”) for new secured bonds (“New Notes”) plus additional consideration consisting of new shares of preferred stock (“New Preferred”).

Read more from Better Be Business Wired.

CARLSBAD, Calif.–(BUSINESS WIRE)–Brendan Technologies, Inc. (OTCBB: BDTE – News), an analytical software company developing advanced commercial software for immunoassay and bioassay testing technologies, has secured a bridge financing totaling $600,000, led by Little Bear Investments LLC as the lead investor and facilitated by Midtown Partners & Co. LLC.

The bridge financing will be used for working capital as Brendan completes its upgraded version of its software StatLIA®. With the upgrade, Brendan will provide software that will be capable of facilitating enterprise-wide lab infrastructures, enhance accuracy and speed in both immunoassay and bioassay testing, provide powerful data analysis graphics and increase the overall quality, efficiency and regulatory compliance required in laboratory testing. Brendan’s existing customer base, including companies such as Amgen, Merck, BioRad and Eli Lilly, should expect the upgraded version to be introduced to the market this fall.

“Securing this bridge financing is expected to enhance Brendan’s ability to continue unabated with the execution of our business model and provide us with the necessary capital to complete the much anticipated launch of our upgraded version of StatLIA®,” said John Dunn II, CEO and Chief Technical Officer of Brendan Technologies. “For years, StatLIA® has been a leading analytical software tool used in the immunoassay testing market, which is reflected in our existing customer base of premiere biopharmaceutical companies. Upon the completion of the upgrade, we expect a successful expansion of StatLIA® in the marketplace.”

Background on Immunoassay Testing

Immunoassays are highly sensitive and specific chemical tests used to detect and quantify extremely minute substances in blood, body fluid and other biological samples, using an immunological reaction. These tests measure the formation of antibody-antigen complexes and detect them via an indicator reaction. Their high specificity results from the use of antibodies and purified antigens as reagents. High sensitivity is achieved by using an indicator system that results in amplification of the measured product. Immunoassays may be qualitative (positive or negative) or quantitative (amount measured).

Immunoassays are one of the world’s largest and fastest growing testing technologies used to diagnose diseases, discover new chemical entities and biological products, provide vital data in the development of drugs in FDA clinical trials, and assist in quality control of drug manufacturing and drug screening. It is also one of the largest technologies used in environmental testing. Currently, $50 billion is spent globally on immunoassay testing, with approximately $1 billion of that being spent on immunoassay software.

About Brendan Technologies, Inc.

Brendan Technologies, a developer and marketer of innovative analytical software, is actively providing software solutions to improve the accuracy, quality control, workflow, and regulatory compliance of immunoassay testing in laboratories in the biopharmaceutical, clinical, research, veterinarian and agricultural industries. The Company’s customers, many of whom are Fortune 1000 organizations, represent some of the largest corporations in their respective fields. Brendan Technologies is currently redesigning and expanding its current product lineup to better capitalize on the growing demand of its target markets for more advanced software.

About Little Bear

Little Bear Investments, located in the heart of Midtown Manhattan, is a merchant bank that focuses on investing in both public and private companies. Our broad range of investment experience includes: tender offers, private placements, PIPE’s, reverse mergers and bankruptcy auctions. Little Bear also offers financial, operational and strategic advisory services. Working with companies large and small, we bring the same disciplined approach to our clients as we do to businesses in which we have deployed our own capital.

About Midtown Partners & Co., LLC

Originally founded in May 2000, Midtown Partners & Co., LLC is an investment bank focused on private placement investment banking opportunities. The investment banking group at Midtown Partners & Co., LLC was founded on the premise that client relationships and industry focus are keys to the success of emerging growth companies. Such companies require investment-banking services from a firm with a unique understanding of the marketplace and the nature of these transactions. Additional information can be found at http://www.midtownpartners.com.

NEW YORK, March 1 — Little Bear Investments LLC (“Little Bear”) announced today that it has once more participated in a private placement to purchase common stock and warrants of Caprius, Inc. (OTCBB: “CAPS” ). This is Little Bear’s second investment in Caprius as it also participated in a round of financing for the Company in February of 2005.

In connection with Little Bear’s participation in the financing, Zachary Prensky, Managing Director of Little Bear, stated “We at Little Bear are very excited to have invested in Caprius for a second time. We believe that the company is uniquely poised to execute its business plan of offering the medical waste industry a safe and environmentally beneficial method of disposing waste.

About Caprius

Caprius, Inc is a manufacturer of proprietary equipment for the on-site disinfection and disposal of infectious medical waste through its subsidiary, M.C.M. Environmental Technologies, Inc. (“MCM”). The Company’s innovative SteriMed technology simultaneously shreds and disinfects solid and liquid regulated medical waste, reducing the volume by up to 90% and rendering it harmless for disposal as ordinary waste. The SteriMed units are economical, compact, efficient and convenient, as well as environmentally friendly. The MCM patented technology offers an alternative to hauling and incinerating medical waste. Industry analysts estimate the medical waste market to be approximately $3 billion in the U.S. and approximately $10 billion worldwide. More information on the Company and MCM can be found at www.caprius.com and www.mcmetech.com.

About Little Bear

Little Bear Investments, located in the heart of Midtown Manhattan, is a merchant bank that focuses on investing in both public and private companies. Our broad range of investment experience includes: tender offers, private placements, PIPE’s, reverse mergers and bankruptcy auctions. Little Bear also offers financial, operational and strategic advisory services. Working with companies large and small, we bring the same disciplined approach to our clients as we do to businesses in which we have deployed our own capital.