Is Bigfish right or wrong about NEP. Is NEP really a fraud?

This morning NEP dropped about 20% due to a newly posted questioning of a part of their operations by a new blog called Bigfish Research. (edit: This link won't work because the site has been suspended)

I read through their article and am now looking at all the 10-Ks myself to confirm or deny the accusations. While BigFish is correct on all his statistics, he paints the data in an extremely negative fashion to "prove" that NEP is a fraud and improve his short position. I have no problem with this as he is allowed to have his opinion and share it, however, I do think that investors should also have an opinion from someone who is long the stock.

All the information Bigfish put out in his blog is verified by what is in the specific reports he mentions he pulled it from. However, if you look at different filings, then the numbers are different. This presents a catch-22 for current and potential NEP investors.
On one hand, maybe the company isn't a fraud because the numbers make a bit more sense in other reports. On the other hand, why can't this company seem to be consistent across their filings. Is their accounting department really bad at making sure their statements match, or are they actually hiding something?

Analyzing Red Flag #1

If you look at the Q3 2009 amended report, the numbers that Bigfish talks about are true. For example, check out Page 18. You'll see that the company does in fact show that their combined revenues for the first nine months of 2009 would have been $76m, if Tiancheng was part of NEP the whole year. This is different then what was posted in the previous 10-Q for Q309.

However, if you look at the 2009 10-k, then the numbers match the initial numbers that NEP posted in the initial 10-Q after the acquisition.
Based on the information on page F-19, NEP would have had $79,362,000 revenues in 2009 if Tiancheng had been part of the company all year. NEP's production division made $51,081,000 in 2009, so Tiancheng had revenues of $28,281,000 for 2009. This means that their total revenues in the first 9 months was $14,704,000.

Note that in 2008 Tianchang's full year revenue was about $14.4mil, so before NEP acquired them they were growing at a reasonable pace, but not one that was extraordinary. The Q409 revenue figure of $13.6mil is certainly a massive jump, and I do agree with Bigfish that NEP very well may have asked Tiancheng to hold off booking revenues in Q3 so that they could be booked in Q4.

Analyzing Red Flag #2

NEP's business did not need to be SAVED. The oil production business profits were just fine, and Tiancheng was simply an additional bonus when it was announced. Its true that Tiangcheng was about half of NEPs business in 2010, but a big reason for that was due to the flooding in Jilin which drastically reduced NEP's oil output for a large part of the year.
Also, it makes sense to me that Tiancheng is able to generate more revenue being joined with NEP compared to operating alone. NEP already had contacts with PetroChina and thus were able to get drilling contracts that Tiancheng couldn't on their own. Tiancheng's margins also should be expected to improve with higher revenues due to economies of scale. Their margins would also go up once integrated with NEP because of cost savings for G&A.

Tiancheng's revenues have gone from $14.4mil in 2008, to $28.3mil in 2009, to $44.9mil in 2010. These are very impressive increases, but many companies have seen these growth rates when they were as small.

Analyzing Red Flag #3

I will agree with BigFish that it seems strange that they didn't mention Beijing Junlun Runzhong Technology Co. Ltd. (“JLRZ”) in the 2010 10-K. It seems like they should have drilled some wells for them, or at the very least, they should have let us know that drilling was delayed or completely canceled.

However, I don't see any issues with the rest of their operation. PetroChina is obviously a real company, and I don't see how they would let NEP pretend for 3+ years that they first sell petroleum to them, and now drill for them.

Also, I don't see why it's unusual that NEP didn't create a press release about the wells drilled for Daqing Shunwei. They drilled 54 for them all year, or about 14/Quarter. Its very plausible that Daqing signed a series of small 5 or 10 well contracts, which would not warrant a press release.

Analysing Red Flag #4

As for the total meters drilled figure listed multiple times in the 2010 10-K, I agree with Bigfish that there is something incorrect, because the company clearly only drilled 306k meters for clients during 2010, but for some reason lists 374k in multiple places in the 10-k. I can think of three explanations for this figure:

1. The company made a mistake in their calculations somehow and didn't catch it. Obviously this would be good and bad. (Bad because it should have been caught by the auditors).

2. The company included drilling done for themselves in the final figure. This seems unlikely because the company only drilled 6 wells for themselves in 2010.

3. The number could be fraudulent as Bigfish believes. The issue for me is that showing this higher number doesn't help NEP look better. Their revenue figures stay the same, so they list the avg revenue/meter as $120, when in reality it was about $147. This makes their operation look WORSE, not better!

Finally, I also noticed the higher revenue/meter drilled in Q4 compared to the rest of the year. Personally, I don't see why this is a red flag. Inflation in China during 2010 was high, and I would not be surprised if NEP was able to negotiate better terms for the wells it drills in Q4, vs the earlier deals they set up in early 2010.

Red Flag #5

This is probably BigFish's worst argument. When NEP bought Tiancheng, their Quarterly depreciation was about $375k. If we assume that they bought their rigs in a reasonably even manner since they started in Dec 2007, then we can assume that they had taken about $1.3mil in depreciation charges already when NEP bought them ($375k/Q x 7 Qs = $2.625m. Divide by 2 to account for gradual purchasing = $1.3mil)

Thus, their initial costs for the 7 rigs were about $13.5million. Lets assume the 4000m rig NEP purchased after the fact was a brand new rig and that the other rigs were purchased somewhat used. I will state that I have no idea how much more a 4000m rig costs then a 3000m or 2000m one, but I'm making guesses here which seem plausible:

3 2000m x $1.45m = $4.35m
3 3000m x $2.10m = $6.30m
1 4000m x $2.80m = $2.80m

Total cost is $13.45m.

These estimates seem completely plausible, at least to me. Of course we could also argue that the amounts are low, and perhaps we could get an opinion from someone which actually know the prices for these things, but to me I don't see how this is a Red Flag.

Red Flag #6

I have not done any additional research on drill rig capacity, but BigFish didn't give a great argument here. First off, we know that they drilled 306k meters, not 374k. So their production was only 1.8 times Eurasia's stated capacity, not 2.6.
The other point is that with 207 rigs, its very likely that Eurasia has many older rigs which are not as efficient as the NEP rigs, which are likely newer.
I don't have the time right now to look deeply into the issue, but BigFish should have used more datapoints.

Red Flag #7

BigFish's argument here is that 42% net margin is impossible. I would argue that it is not, especially when you consider that Tiancheng is doing this as part of a larger company. This means that this net margin doesn't include the additional overhead that they would need to pay if they were on their own.

Also, the oil and gas drilling industry has high gross margins. I took a look at RIG and its competitors and there they show that the average gross margin in the industry was 56%! Tiancheng's gross margin in 2010 was 61%. Thats only 10% better then the industry average.

Putting Everything Together

1. I will admit that the Tiancheng deal has been so good that it could be viewed as "too good to be true." No one can debate this and I wish that NEP would come out with a reasonable explanation for why the previous owner sold. I can think of a couple scenarios though. Perhaps the company was in a cash flow crunch, and the owner sold it because it was either lose it to bankruptcy, or collect $13mil for it.
Also, its clear that NEPs contacts have helped generate additional drilling contracts in 2010, so Tiancheng likely would not have done nearly as well alone.

2. I also agree that the numbers in the financials aren't adding up in all cases. The 374k meters drilled figure is clearly wrong and yet is posted multiple times in the 2010 10-k. Tianchengs 2009 revenues are also unclear because the amended 10-Q and the 2009 10-K have different numbers.
Personally, I believe that the reason for the discrepancy in both cases is user error, rather then fraud. Still, it is not a good sign that neither NEP's accounting departing or their auditors caught these differences in their reviews of the reports.

My personal opinion is that this is a great buying opportunity. Unfortunately I don't have extra cash to take advantage of it, but for me here are the possible outcomes:

1. The company is a fraud. Bagholders lose their full investment. Likelihood: 10-20%

2. The company is legit. In this case they will complete their purchase of the new oil field, and in 2-3 years will start producing large amounts of oil from it. From the $3 level the price of the stock could easily go to $30 in 5 years. Likelihood: 80-90%.

Personally I like those odds and feel that its worth speculating some money you can afford to lose on.


BoeroBoy said...

Thanks Aurelien,
It's a relief to have an unbiased analysis by an existing party instead of a random pop-up blog by a blogger short that came out of nowhere a week ago. I agree with your assessments and I'll hang on to my small holdings.

Aurelien said...

Thanks for the comment. I will say that I do have a slight bias in that I do own NEP stock, so obviously I want it not the be a fraud. I'm trying to be impartial in my analysis though.

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