The 10th Annual New York Value Investing Congress takes place in New York on September 8th and September 9th 2014. ValueWalk will be providing coverage of the event- below is a brand new short from Carson Block of Muddy Waters.

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Carson Block Goes Short 500.com (WBAI)

Carson Block is director of research and founding partner of Muddy Waters Research LLC, a due diligence-based investment firm that conducts extensive accounting and on-the-ground investigations of public companies. Muddy Waters won accolades following its research on Sino-Forest Corp., a China-based forestry company listed on the Toronto Exchange. Shortly after Muddy Waters’ report in June 2011, Sino-Forest lost nearly $6 billion in market capitalization, its auditor resigned and regulators halted its shares. The company filed for bankruptcy and in June 2012, the Ontario Securities Commission filed formal fraud charges against Sino-Forest and its senior management for overstating its timber assets and misleading investigators. In total, Muddy Waters has issued eight “strong sell” recommendations resulting more than $8 billion of downward market cap adjustments, four de-listings and six or more regulatory investigations. Prior to forming Muddy Waters, Mr. Block was an entrepreneur in China and worked as a lawyer in Shanghai. In 2007, he co-authored Doing Business in China for Dummies.

Carson Block: Shorting Against Blue Pill Investing

How to protect yourself as a long investor

Age of Venality

Management

incentives are often short term

CEO’s are largely charismatic

the more successful the CEO, often the less willing to be held accountable

Andrew Fastow (ENE) won CFO magazine award for excellence in 1999 (enron CFO)

Management is better seen, not heard

Reading call transcripts is better than listening to the calls

  • read several quarters at a time to look for disappearing initiatives, changes in language
  • are questions evaded?? which ones?
  • are the questioners the same, if so, do they seem TOO close to mgmt

best to keep mgmt at a distance

watch out for monetizing management

Boards

symbiotic relationship with CEO’s

insulated from negligence liability by BJR, insulated from other liability by D&O insruance

many directors view directorships as perquisites, not responsibilities

“Independent” investigations often shambolic

Lawyers represent the interest of their clients –the people who hire and pay them

Do not count on lawyer reports to uncover anything worthwhile

Auditors:

Auditors represent the interests of their clients

a profession fighting against accountability

level 3 fair value accounting is problematic

key audit work is done by juniors

auditors DO NOT detect fraud

Sell Side/I banks

analyst are not rewarded for skepticism

junior bankers do most of the due diligence

The company’s pay for “market research”

Pretty much China is uninvestable –too much fraud and impossible to account for

No fraudster from china has ever been punished for defrauding N. American investors

How to avoid getting burned

Rackspace Hosting, Inc. (NYSE:RAX): investors lost in the word “cloud”, Block was short the company

They are a plain old internet host…they are not a cloud company

Larry Ellison – the Cloud is not real!  people just replaced the word internet, with cloud (2009 interview)

Sino-Forest Red flags (TRE)

too good to be true gross margins

FCF Negative every single year!!

New short

500.com Ltd (NYSE:WBAI)  Chinese company

market cap 1.2b

p/e 37x

legally in a gray area

licensing framework is unclear

resolution is likely to bring competition and compress margins

MoF prohibits cross border sale of online sports lottery tickets

500.com Ltd (NYSE:WBAI)  accounts for about 24% of Jiangxi’s total lottery proceeds

piper jaffray estimates that online sales of lottery tickets are about 6% nationwide

WBAI reports positie income from lottery winnings

WBAI generated about $2m from lottery winnings

tax status is complex

12.6m of 2013 net income came from a tax benefit (72% of revs)

employee bank accounts used to collect winnings

employee takes winning lottery ticket to be claimed, the winnings are paid into the employee bank account, then transfers it to 500.com, then paid out to winner…..  hmmmm??

claims 20m downloads of it app in LAST QUARTER (app stores show they don’t even have 2m people download the app last qtr)

Muddy waters is short the stock.

UPDATE 9/10/2014 7:00AM EST The previous version of this article may have suggested that Carson is currently short RAX. Carson was in Jan 2013 but covered the short a long time ago as he thinks the company is now fairly valued now