Doing my daily search for investment ideas I stumbled several times across a note from Whitney Tilson of T2 partners and his bet against Interoil (IOC, Financial). It is usually risky business to speak openly about a short position, but Mr. Tilson seems to have a very high level of conviction when it comes to Interoil.
Here is what he wrote:
It says a lot about who owns InterOil when folks on the company’s message boards are saying we’ve gone long the stock based on our 13-F. HA! This is a very large bearish bet for us.
A lot of people make this mistake when reading 13-Fs: managers often own puts (which are also disclosed in the 13-F) or are short a stock (which isn’t disclosed) and then own a small offsetting long position to make it easy to trade around it.
In our case, our 13-F (http://sec.gov/Archives/edgar/data/1327388/000139834410001071/fp0001970_13fhr.txt) shows that as of 6/30, we owned 1,623 put contracts (representing 162,300 shares of stock) on IOC and, in addition, were long a mere 10,400 shares. Puts can be very hard to trade, so we just bought more puts than we wanted and offset the extra amount by buying some stock, resulting in the desired net exposure. Then, if we want to increase or decrease our bearish bet, we can simply buy or sell the stock.
We added to our bearish bet today, as InterOil reported Q2 earnings yesterday (http://finance.yahoo.com/news/InterOil-Announces-Second-prnews-4121957030.html?x=0&.v=1) that reinforced our investment thesis. The earnings and EBITDA (driven by the refinery operation) are irrelevant for a company that has a $2.9 BILLION (not a typo) market cap; what really matters if whether there is, in fact, the Sierra Madre of oil and gas in the areas being explored by InterOil and, if so, whether they have the cash to find it, develop it commercially, etc.
Re. the former, there continues to be no proven or even probable reserves – just more hype and gibberish like this from the earnings release:
The Antelope 2 horizontal well confirmed a higher condensate-to-natural gas ratio of 20.4 barrels per million cubic feet of natural gas, 27% higher than observed at the top of the reservoir. The horizontal well also demonstrated dolomitization and higher porosity deeper in the reservoir than previously modeled.
And re. the cash, this company is going to hit the wall soon. Over the past four quarters, net income is -$1.3 million and free cash flow is -$181.9 million (cash from operating activities minus “expenditure on oil and gas properties” and “expenditure on plant and equipment, net of disposals”, broken down as follows:
Q3 09: -$48.6 million
Q4 09: -$40.7 million
Q1 10: -$28.5 million
Q2 10: -$64.1 million
TOTAL: $181.9 million)
So with no profits to fund such massively negative cash flows, how is InterOil doing it?
Answer #1: Burning through cash (unrestricted cash has declined from $96.4 million a year ago to $31.7 million today)
Answer #2: Taking on debt (the working capital facility – short-term debt – is up from $4.0 million a year ago to $57.7 million today, partly offset by a $9 million decline in a secured loan)
Answer #3: Issuing stock and conversion of debt ($12.8 million over the past 12 months), resulting in the diluted share count rising 16.1%.
Answer #4: Misc. other stuff (“Proceeds from IPI cash calls” ($15.2M in the first two quarters of 2010), “Proceeds received on sale of exploration assets” ($13.9M in Q1), and “Proceeds from Petromin for Elk and Antelope field development” ($5M over the past 12 months).
To summarize, InterOil has only $31.7 million in unrestricted cash as of June 30th and they’re burning an average of $45.5 million of cash each quarter. No wonder the company entered a short-term $25 million credit facility last week (http://finance.yahoo.com/news/InterOil-Enters-Short-Term-25-prnews-1473636862.html?x=0&.v=1) on distressed terms: 10% interest (in this environment!), secured by a 2.5% stake in InterOil’s Elk and Antelope fields. Note that the provider of financing was a very dicey outfit, Clarion Finanz and known stock promoter Carlo Civelli – see http://whitecollarfraud.blogspot.com/2009/07/interoil-john-thomas-financial-and.html.
I’ve spoken to people who are long IOC and have read several reports from people like Whitney who are betting against the company. One thing I have learned for certain is that if there is any whiff of doubt around the morals of management I’m going to take a pass on the long side. And when you have people like Tilson willing to step out publicly and state a bet against a company like this you can bet they have done their homework.
There is nothing wrong with just taking a pass and sitting on the sideline. This drama has a lot left to play out and will be entertaining to watch even with no skin in the game.
