Incredible Wall Street Stories

Sometimes the market provides us with stories that one wouldn’t believe if one weren’t able to observe them with one’s own eyes. Occasionally they involve outright fraud, such as the artificial short-squeeze organized in CYNK earlier this year – a “social media” company based in Belize with a single employee, that never had a single dime in earnings or revenues for that matter, and does not even have a web site (i.e., a shell company).

The company’s market cap rose from an already far too high $17 million to an incredible $6.4 billion in the space of three weeks until trading was suspended by the SEC. By this time, most of the short sellers had already been bankrupted – not only by the huge price rise in the stock, but by the enormous cost involved in borrowing the shares (these borrowing costs seem to actually have been a major feature of the scam). In fact, the most recent information suggests that Cynk Technology Corp. (CYNK) was also tied to a complex money laundering scheme. Amazingly, the stock still trades at 11 cents, presumably because its price has been supported by frantic short covering on the way down. “Pump and dump” schemes are a dime a dozen, but this one was noteworthy because it involved a different and quite innovative method of defrauding investors. Instead of mainly aiming to defraud the buyers of the stock, it was designed from the outset as a way of bilking short sellers. What the perpetrators probably didn’t consider was that the squeeze would drive the price to a level that would alert the authorities.

Pump and dump in CYNK – a sophisticated scheme to bilk short sellers by lending them shares in an essentially worthless company at outrageous borrowing costs and then organizing a squeeze. In the meantime it has been reported that the activity may have been tied to a money laundering scheme 

Still, while the CYNK case is unique among pump-and-dump schemes in some respects, it is still clearly identifiable some kind of fraud.

GTAT’s Shareholders See $1.45 billion Disappear in a Flash

GTAT’s investors by contrast are probably scratching their heads right now, wondering why they have just been hit by a ton of bricks in what appeared to be a perfectly legitimate investment. As things stand, we don’t yet know every detail of this case, but here is a brief summary:GT Advanced Technologies (GTAT) is a putative maker of sapphire glass. This glass was going to be used in Apple’s new line of i-Phones, and Apple in fact advanced some $580 million to the company so it could invest in furnaces and other equipment needed to produce sapphire glass. Something seems not to have worked out as planned though, as the i-Phone 6 series was released sans sapphire glass.

Upon the release of the new i-Phones, a few analysts lowered their rating of GTAT and withdrew their “strong buy” recommendations – but not all of them did. In fact, as of Friday last week, with its market cap at $1.55 billion, the stock still had three “buy” ratings assigned to it by Wall Street’s bien pensants, complete with rather fanciful price targets. If you still needed proof that a great many WS analysts are of no use to investors – in a bull market you don’t need them and in a bear market you don’t want them (we concede of course that there exist numerous exceptions to this rule) – here you have it.

On Monday, the company declared seemingly out of the blue that it would file for bankruptcy, and the stock was hammered for 93%. Similar to CYNK, it probably didn’t go all the way to zero because short sellers used the opportunity to cover.

As recently as in July, GTAT still sported a market cap of $2.8 billion. On Monday, it all disappeared in a flash, as the company’s management announced it would file for bankruptcy 

We wonder how Wall Street analysts covering this company could possibly overlook a small thing such as the possibility of its imminent insolvency. Obviously, such events mainly tend to happen during a stock market bubble, when the guard of investors and analysts alike is down and gullibility reigns. According to a Bloomberg report on the matter, investors were appropriately “stunned” by the event. As one fund manager remarked, he “can’t recall seeing one like this before” – this is probably because such things only happen in the latter stages of major asset bubbles.

Not only shareholder saw their investment in GT wiped out – holders of $434 million in convertible debt issued by the company over the past two years saw their bonds plunge from above par to 31 cents on the dollar in one fell swoop as well.

“Stock and bond market partisans of sapphire screen maker GT Advanced Technologies Inc. (GTAT) saw their loyalty turn costly yesterday.

After opening at $11.06, the stock plunged to 80 cents by the close, wiping out about $1.4 billion of market value after GT Advanced shocked investors with a Chapter 11 filing. Of 14 equity analysts that followed the maker of mobile phone screens, four considered it the equivalent of a buy at the end of last week, according to data compiled by Bloomberg.

“I can’t recall one like this before,” Lawrence Creatura, a fund manager at Pittsburgh-based Federated Investors Inc., said in an interview. Federated did not own GT Advanced shares as of its most recent filing, he said. “Ordinarily, bankruptcies are a ‘slow death by a thousand cuts’ type of affair. This one is unusual in its suddenness.”

Jeff Nestel-Patt, a spokesman for GT Advanced, didn’t return a phone call and e-mail seeking comment.

While Apple Inc. (AAPL) agreed last November to prepay about $578 million to GT Advanced to build furnaces that make synthetic sapphire, the company’s newest smartphones didn’t include the material. GT Advanced listed assets of $1.5 billion and liabilities of $1.3 billion as of June 28, according to a Chapter 11 filing yesterday in U.S. Bankruptcy Court in Manchester, New Hampshire. The company plans to continue operations during its reorganization.

GT Advanced has $434 million of debt in two convertible offerings, each raised in the last two years, according to data compiled by Bloomberg. Its $214 million of 3 percent unsecured convertibles with a December 2020 maturity date plummeted 77 cents to 31 cents on the dollar yesterday, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

“This is just off the charts,” said Bill Feingold, co-founder of Valhalla, New York-based Hillside Advisors LLC and author of “Beating the Indexes,” a book about convertible bonds. To trade well above par and then “go to bankruptcy in one fell swoop, you just simply don’t see it.”

(emphasis added)

So how come the cognoscenti on Wall Street didn’t see this one coming? As an aside, readers should file this event away as a factoid that will eventually become relevant for the US stock and junk bond markets as a whole: the current almost unprecedented happy bullish consensus will fail to forecast the eventual denouement of the broader market as well.

The excuses so far are not much of a consolation or likely to provide much confidence in stock ratings. It was just a “wrong call” – sorry, folks:

“GT Advanced, based in Merrimack, New Hampshire, was losing favor with analysts before its bankruptcy filing, though not enough to suggest the company was headed for Chapter 11 protection.It ended last week with a consensus rating of 3 in a system where buy ratings score a 5 and sells score a 1. The average stock in the Russell 2000 Index is rated 3.85, data compiled by Bloomberg show.

Jeffrey Osborne, an analyst at Cowen & Co., suspended coverage of GT Advanced yesterday. He had rated the stock outperform, the equivalent of buy, since August, when he began coverage with a price target of $19.

“We have gotten this call wrong,” Osborne wrote in a note to clients yesterday. “We did not appreciate that the company appears to have bitten off more than it can chew in regards to the relationship with Apple.”

(emphasis added)

Note that Mr. Osborne’s price target was a full 70% above the stock’s closing price on Friday – one trading day prior to the announcement. In other words, last week he still held that a company about to file for bankruptcy deserved a market cap of $2.6 billion.

One wonders what this assessment was based on. As of last quarter, the company had total 12 month trailing revenue of $153.7 million, which produced negative levered free cash flow of $267 million and resulted in reported annual trailing losses of $204 million. In fact, it seemed rather obvious just from these figures that the company could be headed for trouble, especially in light of the fact that it had issued $434 million in bonds and had received a $580 m. prepayment from Apple. As of last quarter, $333 million of these cash infusions were still left, an amount the company was slated to burn through in little over a year. So it either had to have very good prospects of producing a major increase in revenue soon, or it was going to require additional outside funding. Given that its sapphire glass was not held to be ready for use in Apple’s new line of i-Phones, a major red flag had just been hoisted with regard to said prospects.

In addition, the company’s insiders have been selling its shares hand over fist on “autopilot” for as far back asthe records on Yahoo’s insider transactions page go. There hasn’t been a single purchase at market prices in the past two years and after the stock reached its peak in July this year, there has been a flurry of sales by executives, with a number of rather sizable transactions recorded in July and August. While not enough is known to allege impropriety at this stage, one does wonder since when the board of directors was aware that the company was headed for bankruptcy.

Lastly, there was at least one group of market participants that proved to be a lot smarter in analyzing the company’s prospects than Wall Street analysts, namely short sellers. As of September 15, more than 48% of the company’s share float had been sold short. Such a big short position is often a warning sign all by itself, which analysts apparently preferred to ignore.

Conclusion:

In a way the GTAT saga strikes us as a potentially bad omen for the market as a whole. The fact that analysts and major institutional investors could completely “miss” that the company was on the verge of bankruptcy is quite astonishing. Unless it turns out that there was fraud involved – which we don’t assume to be the case at the moment – this is something that typically only happens during a major financial asset bubble. Note here that even the few analysts who presciently assigned a “sell” rating to the stock are saying they did not expect anything of this sort to happen:

“Analysts at CLSA Ltd., Raymond James Financial Inc. and Dougherty & Co. lowered GT Advanced to sell or an equivalent rating during the past two months. They joined EVA Dimensions LLC, which put a sell recommendation on the Merrimack, New Hampshire-based company’s shares in July 2013.

“To be clear, we did not see this coming,” Pavel Molchanov, an analyst at Raymond James, wrote yesterday in a report. “We don’t think anyone else did either.”

The Houston-based analyst cut his recommendation on Aug. 28 and wrote then that he was making “a tactical rating change” after the stock price more than doubled in 2014.”

(emphasis added)

While this is obviously a “company-specific” event in a small specialized field of technology, we are still stunned by the extremely high valuation investors accorded the company previously and by the fact that it could go “quietly” bankrupt right under everybody’s nose. The seemingly rather nonchalant reaction to the event (“sorry boys, we got that call slightly wrong”) should also raise eyebrows in our opinion.

At the moment, many people are still sitting on major paper profits as a result of the ongoing asset mania, so the negative reaction to this event will probably be dampened by that fact. However, once a bear market gets going, people won’t be so forgiving anymore. Then the search for scapegoats will be on, just as happened when the technology mania of the 1990s broke and when the housing boom of the early 2000s turned to bust.