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Lakewood: Short Celltrion And Snoop-Dog Backed Weed Firm

Lakewood Capital Management, the mutl billion dollar hedge fund led by Anthony Bozza, is calling the top of the marijuana stock boom.

The firm revealed short positions in two major cannabis companies in its full-year and fourth quarter letter to investors, a copy of which has been reviewed by ValueWalk. The Lakewood hedge fund is short Canopy Growth, and Aurora Cannabis as Bozza and team believe that these pot stocks are highly overvalued and trade no nothing more than hot air.

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“Heading into the final months of 2017, each of these public companies sported market capitalizations that were nearly impossible to rationalize” the letter notes, “but nonetheless, the stocks saw their values more than triple in just a few short weeks around year-end as focus turned to the legalization of recreational marijuana in California on January 1, 2018” it continues.

The Lakewood letter goes on to say that “Despite the recent mania around the legalization of recreational pot in California” none of the companies attached to these surging stocks “sell at all into California (or anywhere else in the U.S. for that matter), since that would, of course, be illegal.”

Nonetheless, despite this technicality, investors seem to be more than happy to buy into Canopy and Aurora’s growth story. At the time of writing, these two firms have a market capitalization of C$7 billion and C$6 billion respectively that’s despite the fact that the team at Lakewood calculates “Canopy Growth’s current production capacity can be recreated for less than C$150 million, and Aurora’s current production 8 capacity can be recreated for less than C$100 million.” With this being the case, Bozza and team believe it’s “not a matter of if, but when these stock prices collapse.” If they don’t, then we “should all be moving to Canada and growing pot” because one $100 million production facility should be worth “$5 billion of market capitalization in the current environment.”

Specifically, the letter notes:

If there are any investors in the world riding as high as the shareholders of the aforementioned Celltrion, they are likely to be found holding the publicly-traded marijuana stocks. Ever since recreational marijuana was legalized in Colorado in 2013, retail investors have been in a frenzy to try to play the impending cannabis boom, often being sucked into many stock promotions and scams along the way.

Despite a trend towards increased legalization of recreational marijuana at a state level, it is still illegal to 7 sell pot under U.S. federal law, and consequently, investors have flocked to Canadabased cannabis companies that operate safely outside of the purview of the U.S. government. Enthusiasm has been particularly acute in the past year as anticipation grows for Canada to legalize marijuana for recreational use in mid-2018. Heading into the final months of 2017, each of these public companies sported market capitalizations that were nearly impossible to rationalize, but nonetheless, the stocks saw their values more than triple in just a few short weeks around year end as focus turned to the legalization of recreational marijuana in California on January 1, 2018.

It has been hard to come across a retail investor rag or stock blog without hearing about some way to play this theme, and countless web sites are now devoted to investing in this exciting industry. Google searches for “marijuana stocks” quadrupled in the month of December alone, new ETFs were created to give investors exposure to this red-hot space, trading volume in the public companies skyrocketed, new capital was being raised on an almost daily basis, and before you knew it, Canada had a new class of multi-billion dollar companies that were little more than business plans just a few short years ago.

Despite the recent mania around the legalization of recreational pot in California, there is a little problem: none of these companies sell at all into California (or anywhere else in the U.S. for that matter), since that would, of course, be illegal. The fund is short both Canopy Growth, a C$7.5 billion market capitalization company, and Aurora Cannabis, a C$6.5 billion market capitalization company. I suppose it’s easy to understand the appeal of these stocks to the casual investor – strong regulatory momentum, constant press coverage, growing public acceptance, an absence of large incumbents and an enormous, rapidly expanding market opportunity. These attributes would serve as the foundation of an intriguing investment thesis if getting into this business wasn’t so simple.

Canopy Growth will lead you to believe it is building competitive advantages through its industry-leading capacity expansions or partnerships like the one it struck last year with Snoop Dogg and his “Leafs by Snoop” brand or by potentially one day selling cannabis-infused beverages through a relationship with beer, wine and spirits company Constellation Brands (which would be illegal in the U.S.). Aurora Cannabis might tell you they have an advantage as the only grower in the lowcost Alberta region nestled in the Canadian Rockies (but only if you ignore the fact that no one else grows there because of negative 10° Fahrenheit weather conditions or the frequency of hail storms that at a minute’s notice could destroy their entire greenhouse operations) or through their accomplished management team led by Alberta’s “youngest master electrician” and founder of one of Canada’s “Top 50 Fastest-Growing Companies” (which actually is just a tiny Alberta-based construction permit and inspection company called Superior Safety Codes).

But, what these companies certainly won’t tell you is that the number of licensed producers in Canada has doubled in the past year and is growing rapidly by the week, it costs just a few thousand dollars to obtain a cultivation license, the industry has collectively raised an astonishing C$2.1 billion in recent quarters and leading producers announced plans for a greater than ten-fold increase in their capacity over the next eighteen months.

Remarkably, we estimate that Canopy Growth’s current production capacity can be recreated for less than C$150 million, and Aurora’s current production 8 capacity can be recreated for less than C$100 million, just a small fraction of their current enterprise values. The industry’s stock valuations have become so extreme that one co-founder of a leading Canadian producer told us he would not “touch [these stocks] with a ten-foot pole” and that he thought they were “way overbought” even before the recent run-up in the stock prices. Simply, we believe it is not a matter of if, but when these stock prices collapse… otherwise we should all be moving to Canada and growing pot. After all, a $100 million production facility should be good for at least $5 billion of market capitalization in the current environment. This cannot and will not last.

Another short is described by Lakewood as follows:

Over the years, we have shorted many egregiously overvalued, overhyped stocks, but we have rarely encountered a situation more distorted and absurd than Celltrion, Inc. Celltrion is a Korean pharmaceutical company founded 15 years ago with an initial investment of less than $50,000 by the company’s Chairman Seo Jung-jin (“JJ Seo”). In the past three years, the company’s stock price has increased sevenfold, making Celltrion the third most valuable company in the Korean market.

Together with its sister companies, Celltrion Healthcare and Celltrion Pharm, Celltrion sports a combined market capitalization of around $60 billion, approaching the size of leading pharmaceutical companies like Eli Lilly, AstraZeneca and Biogen. The Celltrion story includes links to Korea’s largest ever corporate fraud, allegations of insider trading and stock manipulation, increasing competitive pressures and complex relationships between Celltrion’s various entities that mask the true underlying demand for its products. Celltrion was formed in 2002 to develop biosimilars, which are effectively generic versions of biologic drugs.

The company’s founder and Chairman, JJ Seo, previously served as a strategic advisor to Daewoo Motor, where he was “handpicked” by Daewoo’s chairman Kim Woo-Choong according to press reports. The Daewoo Group’s collapse in the late 1990s has been called the “biggest accounting fraud in history, surpassing WorldCom and Enron,” and resulted in Mr. Kim fleeing Korea to live as a fugitive for more than six years. He ultimately returned to Korea, where he was sentenced to ten years in prison and fined $23 billion relating to Daewoo’s collapse. In addition to Mr. Seo, both of Celltrion’s co-CEOs previously worked at Daewoo Motor.

Perhaps Mr. Seo and his colleagues learned a thing or two from their time at Daewoo as their 2013 battle against short sellers resulted in regulators uncovering stock manipulation and insider trading at Celltrion. Specifically, an official at Korea’s Financial Supervisory Service (“FSS”) stated that “it was Seo who manipulated the stock price… because some of its affiliates, including Celltrion GSC, had received loans backed by their stakes [in Celltrion, Inc.].” Further, FSS officials told local press that “Seo scooped up shares just before the company announced a share buyback plan in April.” In response, Celltrion claimed to be “dumbfounded” by the news reports regarding what it called “countermeasures taken against certain abnormal short-selling of Celltrion shares.”

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This does not appear to have been an isolated incident as a 2013 Bloomberg article highlighted three instances of alleged stock manipulation. Celltrion generated a lot of investor interest when it gained significant market share across many European markets by introducing the first approved biosimilar version of a drug called Remicade in 2015. However, after initially enjoying no competition for its Remicade biosimilar, a second biosimilar has been launched by Samsung, with other competitive launches on the horizon. These drugs are typically sold under contract with European governments, and as these contracts are re-bid, Celltrion will likely either lose market share to these new players or be forced to dramatically lower its pricing. In the U.S. market, Celltrion and its marketing partner, Pfizer, have struggled to gain market share with the Remicade biosimilar, obtaining just two percent market share after more than one year on the market.

Meanwhile, Samsung’s new Remicade biosimilar has been introduced in the U.S. at a 35% price discount to branded Remicade, well below 6 Celltrion’s initial 15% discount, likely forcing Celltrion to further reduce its price to maintain share. Additionally, Celltrion’s U.S. marketing partner Pfizer just received FDA approval for its own Remicade biosimilar program in December 2017. We suspect that Pfizer may either eventually drop Celltrion’s product in favor of its own Remicade biosimilar (where it would keep 100% of the economics) or at least use the threat to extract better terms from Celltrion. The company’s only other approved product, a biosimilar of Rituxan, is now facing competition from a recently-approved drug from Sandoz with several other competitors expected to launch by 2019. The outlook is even murkier for Celltrion’s other development programs, where Celltrion is not expected to be first to market and will face multiple competitors.

Curiously, Celltrion created a corporate structure involving multiple entities that is ripe for abuse, allowing Celltrion’s financial results to often look much better than the economic reality of the business. Celltrion, Inc. sells its products to a related entity called Celltrion Healthcare, which then sells the product to the ultimate marketing partner (such as Pfizer or Teva). In exchange, Celltrion Healthcare keeps roughly 35% of the economics. Even though these are related entities that are both effectively controlled by Mr. Seo (who owns roughly 20% of Celltrion, Inc. and 37% of Celltrion Healthcare), product sold to Celltrion Healthcare is recognized as a sale at Celltrion, Inc. regardless of when (or if) the product is ultimately resold to a marketing partner.

Therefore, independent of the end market demand for Celltrion’s products, this structure has allowed Celltrion, Inc. to sell product to Celltrion Healthcare and recognize revenues and profits on the transaction while Celltrion Healthcare simply builds inventory. The key to sustaining this arrangement is raising cash to fund the working capital needs at the two entities. Unsurprisingly, Mr. Seo took Celltrion Healthcare public last year and raised $900 million for what one research analyst noted was simply to allow them “to pay accounts receivables [to Celltrion, Inc.].”

We estimate that this circular relationship has resulted in Celltrion Healthcare accumulating roughly three years of inventory on its balance sheet.

Assuming a more normal level of inventory, we believe that Celltrion, Inc. has recognized at least $1.4 billion of revenue over the past few years in excess of the true end-market demand. By our estimates, Celltrion, Inc.’s true underlying revenues and operating profits are likely 50% below reported levels, placing the stock at around 100x EBIT. We believe increasing competitive pressures around the company’s existing products and future products will limit revenue growth. Based on our detailed discounted cash flow analysis, we estimate Celltrion, Inc.’s fair value is just ₩25,000 per share, more than 90% below the current trading price.

Lakewood  returns

The Lakewood hedge fund generated a net gain of 0.1% in the fourth quarter, the full year net return was 8.3%, and the fund’s volatility was only 3.7% according to its fourth quarter letter. The firm managed to achieve this steady performance with an average cash balance of 24% throughout the period under review.

As well as betting against Canadian pot stocks, the Lakewood hedge fund is also betting on BMW according to its letter. BMW is, in Bozza’s view, one of the most undervalued publically traded automakers with a cash-adjusted forward P/E of 6. Cash currently accounts for around 30% of the firm’s market cap today. This is a sum-of-the-parts story — the market has failed to realize the value that has been created here. Specifically, Lakewood’s letter notes that over the past four years “net cash has increased by more than 55% …to almost €29 per share.”

Meanwhile, the group’s financial services business has grown its tangible book value by a similar 50% and as a result, net cash and the financial services business “amounts to around 50% of the current share price.” As these two businesses continue to grow, there’s protection on the downside for investors while the core auto manufacturing business trades a low single-digit multiple.

Only a matter of time before value returns

The Lakewood hedge fund is a value fund at its core. In the current market environment, however, value investing is not in favor, but Anthony Bozza believes that it’s only a matter of time before value’s outperformance returns. While he stops short of placing an exact timeframe on the return of value, in the fourth-quarter letter Lakewood’s manager says that he’s certainly a value environment “will return.” He goes on to say that today, it is important to realize that the market “looks very different than it has in years past” thanks mainly to the rise of the FAAMGs.

Apple, Alphabet, Microsoft, Amazon and Facebook now account for over $3.5 trillion of market capitalization, which is nearly “400 times larger than the median publicly-traded company market capitalization.” Together, these five stocks are larger than 2,200 of the Russell 3000’s constituents. This is important because, as Bozza writes in his letter, stock picking should “provide an increasingly differentiated result” as the market is increasingly driven by just a handful of companies and the broader market result is “tethered to the fate of a single, richly-valued industry sector.”  The Lakewood hedge fund believes that its focus on value will help it produce steady returns for investors, with reduced volatility in this environment.

One short bet that has not worked out? A Chinese one. Lakewood notes

I discussed our China Evergrande short in our second quarter 2017 letter. Unfortunately, this stock proved to be one for the history books during the year with its market capitalization swelling to $45 billion by year end, creating more wealth for its CEO in 2017 than anyone in the world not named Jeff Bezos. This is nothing short of remarkable for a company that has failed to generate positive operating cash flow for eight straight years (in fact, operating cash flow has been negative for 11 of the past 12 years). Positive sentiment around the China equity markets, an improved China property market, aggressive share buybacks, share purchases from entities with connections to the CEO and shadowy capital raises are all to blame.