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I have been investing in Stocks and Options in my own accounts for about 4 years. I graduated with an MBA from Maharishi University of Management in 2007, having previously graduated with a BA in Business Administration from the same school in 2006. I would like to work in the industry as a... More
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  • Is Bigfish right or wrong about NEP. Is NEP really a fraud? I don't think so! 11 comments
    Apr 13, 2011 4:18 PM | about stocks: CNEP
    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.

    Disclosure: I am long NEP.
    Stocks: CNEP
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Comments (11)
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  • We have posted a copy our NEP report at seekingalpha


    Thank you for "attacking" to our facts instead of attacking us like others. We will respond to you soon as we need to bring up our website asap.
    13 Apr 2011, 05:42 PM Reply Like
  • Author’s reply » Your welcome Bigfish. I always try to do that since it always pays to try to look at something from another opinion. I still think that there is a strong chance that NEP is legit, but clearly there are at least a few problems there. Hopefully they are small ones that can be fixed.
    14 Apr 2011, 01:19 AM Reply Like
  • Maybe you're right aurelien, but i will never ever buy another chinese small cap stock lost alot of money on this one, the messages one can read at the yahoo board are just hilarious
    they think they know it all the high short position tells a different story imho, if you haven't read the story of CBEH yet you should it's just mindboggling how far they go to defraud the investors, unless someone goes to china and does a surveillance of the company and monitors the number of trucks entering and unloading oil, unless someone goes to the fields and watches their drilling activities, unless someone proves their cash balances, i won't trust it anymore, c'mon buying nep is gambling far more reputable companies have committed fraud and denied it until the very end
    14 Apr 2011, 01:12 PM Reply Like
  • Author’s reply » Buying any stock or for that matter any asset is a gamble on some level. You think all the people buying homes in 2006 thought they were gambling with their money? They assumed hosues were going to keep going up because they always did, until they didn't.


    Of course there is a risk NEP is a fraud, but I think that risk is only 10-15% and the upside if it isn't is more then worth the risk.
    15 Apr 2011, 10:00 AM Reply Like
  • That's why there are both investors and gamblers in the market.
    15 Apr 2011, 11:09 AM Reply Like
  • and the few problems you mention, you view them as harmless, well i don't, this is a very amateuristic company at best and maybe a very frauduleus as well! My guess is that some people know alot more then you and i do, maybe the former CFO disclosed some vital information, maybe someone with deep pockets hired a firm to screen the company i don't know, it's all in the stock price imho.
    A legit company won't be shorted with such a low p/e, cash on hand, and high oil prices, just don't believe it.
    15 Apr 2011, 10:06 AM Reply Like
  • > some people know alot more then you and i do


    This is the word from an intelligent investor.


    The previous CFO resigned around Sep 2010. The new CFO has not been working for more than 6 months. Based on his slang, we don't think he is a native chinese but more an american chinese. We do not know how he manage to oversea the operations. He didn't even able to spot the $120/meter number is wrong when he announced it.


    One of the director is the previous CEO. He is now "on leave" due to piggy banking the company bank account and now waiting to be sue in multiple lawsuits.


    The other independent director is the CFO of CAGC, which counter is suspended until today. Auditor resigned and they are unable to filed for 10K, exact same situation as CCME and UTA.
    15 Apr 2011, 11:08 AM Reply Like
  • furthermore i like to add, aurelien, that i listened to the entire cc, and i must say that i was not particulary impressed hearing to this cfo, he sounded like just graduated, unsure, shaky voice, etc, you listen to that cc, if it's still available online, and tell me that this cfo inspires confidence...
    if you add all things up this is all very suspect, the best thing one can do is to simply avoid this stock or wait until the mess is cleared out and institutional investors get back onboard, if that ever would happen which i highly doubt. There would be plenty of upside left to profit from
    'if something sounds to go to be true, it is'
    'where there is smoke there is fire'
    one can choose to dismiss these wisdoms as simplistic or generalistic but they hold alot of merit (i learned the hard way)


    disclaimer: no affiliation whatsoever with bigfish
    english is not my native language
    15 Apr 2011, 12:07 PM Reply Like
  • Author’s reply » The new CFO is young and has gone to school in the U of California system, so obviously he has been speaking English a lot more then the others at the company. But I was not overly impressed with his English either listening to the CC, which led me to believe that he is actually from China and came here for college. You may very well be right though.
    The thing with most young people is that while they may be quite qualified for the job, they may not be as comfortable speaking in public situations, especially if English is their 2nd language. At my university there were a lot of foreign students in my accounting classes who were extremely intelligent and spoke quite well when in one on one situations, but then got very nervous when making presentations in front of the group.


    By waiting for "institutional investors" to buy back in, you are giving up the largest gains in an effort to feel "safer" about buying the stock. I would much rather take a risk on a stock that I feel is undervalued before they arrive, so that I enjoy the price appreciation when they buy in.


    @Bigfish: I realize that you may still be short and thus need to present everything in the worst light possible. But to be fair to investors you should have pointed out that no company funds were found to be lost in the "inappropriate transactions" done by the CEO which led to his resignation. In fact, the CEO transferred funds between company and personal accounts to pay for various company expenses. This is something that many small business owners do all the time. This doesn't exonerate him because he should know that as a public company things need to be done a certain way, but I believe that the CEO meant no harm, and the audit agreed.


    I understand why you are bringing up all the negatives on NEP, since you are trying to make money off being short NEP. I already know about all the negatives you are bringing up (although I had not caught the two discrepancies in the filings, so I'm happy that you brought my attention to them), and I'm willing to risk my money that NEP is legit.


    If this company is a fraud, I will likely lose 100% of the money I invested in it. But if it isn't and they complete the purchase of the Durimu production rights, then I think that in 5 years the stock can be at $30+.


    As long as my perceived odds of the company being a fraud are less then 80%, then this speculation has a positive expected outcome.
    16 Apr 2011, 11:33 AM Reply Like
  • @Aurelien, we respect your decision on this one.
    16 Apr 2011, 01:23 PM Reply Like
  • Why NEP is real? Read this, if can:



    Note the address and name of the defendant. That is the previous CEO of NEP and the address of the current NEP headquarter.


    Also note the oil wells mentioned in the content of the legal record.
    18 Apr 2011, 02:14 PM Reply Like
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