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Sri Lanka – Do The Elections Represent A Green Or Red Light To Investors?

Summary 2-term President Rajapksa loses despite calling election 2 years early. President Sirisena calls for National Government in ‘Rainbow Coalition’. China’s Economic Influsence likely to be reduced, but any shortfall likely to be made up from elsewhere. India likely to play a more prominent role in economic activity. The election is a milestone in Sri Lanka’s maturing democracy and may well represent a milestone in its economic progression. Background On Thursday January 8th 2015, Sri Lanka went to the polls in a Presidential election. This election had been called 2 years early by President Rajapaksa following evidence of declining support for a President that had once been hailed as a national hero . Indeed, his party’s previous dominance had allowed him to change the constitution and permit his seeking a third term. However, despite this wavering support, few expected him to actually lose the election. In the event, Maithripala Sirisena, a former health minister in Mr. Rajapaksa’s cabinet, won the election and was immediately installed as President. Whilst polls had shown the 2 candidates to be level pegging, this result remained shocking. It is thus necessary to consider whether this is evidence of a maturity in Sri Lankan politics or a dangerous change of course following a period of solid economic advance. The Election Despite rumors that elements of the police and army were intimidating anti-Government supporters prior to the election, the poll went ahead in a relatively peaceful fashion. Around lunchtime on the 9th, President Rajapaksa conceded defeat and left the Presidential Residence. That evening, President Sirisena was inaugurated as President and congratulations poured in on a smooth transition from the country’s neighbours and indeed from US Secretary of State Kerry . However, on January 11th, news emerged that the transition may not have been as smooth after all. An aide to President Sirisena announced that President Rajapaksa had approached the police and military seeking support to remain in office. An attempted coup was claimed . However, even if this is correct, the police and military refused to support Mr. Rajapaksa and a peaceful transition has been effected. It seems highly unlikely that Mr. Rajapaksa will make any further attempt to unseat his successor following his rejection by the security forces. Moreover, it is likely that this initiative will be used by President Sirisena and his supporters led by the United National Party (‘UNP’), as a way of pressuring Mr. Rajapaksa’s Sri Lankan Freedom Party (‘SLFP’) ahead of April’s parliamentary elections. From this perspective, it seems likely that the Rajapaksa family’s dominance of Sri Lankan politics (and indeed business life) is at an end. Winners and Losers The principle losers from this election are the Rajapaksa family and China. It was no secret that members of the Rajapaksa family had benefited from their family connection to the President. Whether by holding official office or by their involvement in business deals, the ‘first family’ had clearly benefited. One of the first questions private equity or strategic investors made was which part of the family would be involved and what their expectations would be. Their involvement in the country’s business life cannot be removed overnight. A comparison may be made with some of the business associates of President Suharto of Indonesia whose influence certainly waned following his removal from office, but didn’t disappear. However, it is equally clear that Mr. Rajapaksa’s loss was at least partially owing to discontent with the nepotism that had marked his rule. Many of the transactions in which they had been involved were with Chinese investors . Indeed, a simple overview of Sri Lanka’s international relations during President Rajapaksa’s rule involves China supplying the armaments and finance required to extinguish the LTTE and in return being given a prominent role in the country’s economic expansion. Whilst this certainly involved providing access to money and equipment that has propelled the rebuilding of Sri Lanka’s infrastructure at a rapid rate, critics pointed to the Chinese investment as being a quid pro quo for securing a naval base in the Indian Ocean. Such Chinese involvement naturally put pressure on Sri Lanka’s relationship with neighbouring India. President Sirisena has already talked about China being a good friend to Sri Lanka but warned about not being behoven to any one nation. Additionally, his election manifesto included the cancellation of the Colombo Port City project, a US$1.3 billion project to reclaim land and build everything from high rise offices and apartments to a Formula 1 Grand Prix track. If he carries out these promises, it is clear to annoy China on both economic and strategic grounds. Indeed some have hailed the defeat of President Rajapaksa as destroying China’s overall Indian Ocean Foreign Policy and placing a dent in its ambitions to build a global network of ports. This is likely to be exaggerating things a little, at least at this stage. It is easy to point to India as being the strategic winner from this election. It understandably held concerns about China’s influence both economically and militarily in Sri Lanka. Additionally, the economic policies of the ruling BJP are more in line with the UNP in Sri Lanka than they were with the more left wing Rajapaksa administration. Additionally, the religious minorities of Sri Lanka were solidly behind President Sirisena, and polls indicate that the size of their turn out was a major influence in his victory. Whilst President Sirisena and his key supporters are Sinhalese, it is likely that their policies will be more accommodative of minorities than had been the case with the previous administration. Hence his call for a ‘rainbow coalition’ Invest or Wait? Let’s consider the key questions at this time: · Will President Sirisena change economic course in Sri Lanka to the detriment of investors? o Highly unlikely. His key supporters (UNP) have a more pro-business posture than the SLFP and have been critical of policies (such as the land reform bill) that were deterring to foreign investors. · What will the impact be of cancelling the Colombo Port City project and the planned integrated resorts (casinos)? o The Port City was certainly a massive project and the construction and engineering would certainly have added to the local economy. However, there were major doubts about its ambition and viability. o Given recent revenue contraction in casinos from Macau to Singapore and the planned launch of casino based projects in many other East Asian countries, it is questionable whether building such projects in Colombo would have had a big impact on tourist arrivals and expenditure. Sri Lanka has a wealth of attractions for tourists and many would argue that it can continue to accelerate its tourism industry without resorting to gambling. · Are the upcoming Parliamentary Elections important? o President Sirisena has pledged to reverse the trend of increasingly centralized Presidential power that evolved during President Rajakasa’s terms and strengthen parliament. However, this may be the largest uncertainty given the composition of the coalition which supported his candidacy. o There is little doubt that this coalition was more ‘anti-Rajapaksa’ than it was ‘pro-Sirisena’. Equally, that Sirisena comes from the left-leaning SLFP but now is supported by the right-leaning UNP creates uncertainty. He talks of a “rainbow cabinet’ but this may turn out to be a more effective sound bite with echoes of Mandela than a sustainable coming together of previous enemies. o President Sirisena now has 3 months during which he must bring together elements of multiple parties into a coalition which will support him and demonstrate leadership prior to the election. This will require an impressive level of political maneuvering and only time will tell whether he can pull this off to create a balanced but effective government. The worst case scenario is for the coalition to fracture and leave him without a power base. o His Prime Minister, Ranil Wickremsinghe, was the driving force behind the selection of Mr. Sirisena and is the leader of the UNP. The day to day relationship between these two gentlemen is going to be critical as if Sirisena is regarded as being a puppet of the UNP, then the coalition could fracture rather easily. · Should we be concerned about China being annoyed? o In a word…’No’. Whilst there is little doubt that a return of Rajapaksa would have been China’s preference, they will not want to endanger their access to this strategically important island. Whilst the military benefits of Sri Lanka were often focused upon, the economic benefits of having a trans-shipment option that is lower cost and arguably more convenient to Singapore or Malaysia is also key to Chinese interests. o As mentioned above, this may also allow India and Sri Lanka to become friendlier, particularly given the friendship of Messrs Modi and Wickremsinghe. It would be no surprise if Mr. Modi was one of the first visitors to Sri Lanka, bringing with him promises of additional trade and support. · What about the response of other Countries? o The removal of Mr. Rajapaksa who was the architect of the crushing of the Tamils may bring Sri Lanka closer to its Commonwealth brethren as well as the US. This may well translate directly into expanded financial support as well as giving the country the ability to face the events that accompanied the ending of the civil war without being punished for retaining as President the architect of these events. o It is likely that international relations will improve under Mr. Sirisena and Sri Lanka may once again focus on promoting its many strengths rather than defend its recent history. Conclusion Whilst there are reasonable uncertainties about President Sirisena’s political leadership and his ability to build a sustainable coalition, the positives from this election exceed the doubts. International investment will be more balanced and strategic investors are less likely to be frozen out by preference for ‘first family’ initiatives or Chinese investment. Despite this, credit has to be given to President Rajapaksa for the great strides that Sri Lanka has made over recent years. The country now has a solid foundation of infrastructure including power generation and transportation from which it can build. In m y previous article , I argued that there were many reasons to be positive about Sri Lanka over the coming decade. I see no reason for concern that these reasons have been diluted and indeed believe that stronger growth can now be achieved. Today, Pope Francis arrives in Sri Lanka on an official Papal visit. The timing is appropriate as he will be being greeted by a President who has made reconciliation between religions a key issue. From this perspective, it is an effective ‘Christening’ of the new administration. Only time will tell whether President Sirisena will reward the electorate’s confidence, but the signs are positive and assuming that he can harness the spirit of co-operation and renewal that Pope Francis is certain to preach, the country is set for strong further growth. Investment options for prospective investors in Sri Lanka remain limited. The Ceylon Stock Exchange is small, illiquid and volatile. In essence, it is more of a private equity market for the time being. However, we believe that this will change over coming months as Sri Lanka focused investment vehicles emerge. To this end, emerging market investors should keep at least one eye on Sri Lanka given its strong potential.

Be A Value Investor Without Doing The Work: The Magic Formula

The Magic Formula from Joel Greenblatt’s Little Book That Beats the Market sounds like a cheap gimmick, but is in fact a robust value investing strategy. When individuals implement the Magic Formula in a disciplined way, they buy above-average companies at below-average prices, which is by definition value investing. The only way to succeed with the Magic Formula is to avoid behavioral bias. That means following the strategy in a rote and mechanical way, with no tweaking. You have to stick with it! Most investors can’t, which is actually why the Magic Formula will continue to work. Despite the recent availability of Magic Formula alternatives (including from Joel Greenblatt himself), the simple Magic Formula, applied strictly mechanically, remains compelling for disciplined long-term investors. Do you want to be a value investor but have no idea how to read financial statements? Or maybe you just don’t have the time to do your own proprietary research. Fear not! The Magic Formula will do it all for you. OK – it all, down to the name of the strategy, sounds very, very suspicious. I know it turned me off immediately when I first saw it. It’s the same reaction I had when I saw the title of Joel Greenblatt’s book describing the Magic Formula, The Little Book That Beats the Market (or as it’s now known, The Little Book That Still Beats the Market ). It sounds almost as bad as his other big book, You Can Be a Stock Market Genius . (Of course, that book somehow managed to launch a fleet of a thousand hedge fund manager careers, after the same methods made Greenblatt many millions of dollars personally.) But consider this. This stigma associated with the name the Magic Formula is actually a huge boon to anyone that cares to practice the Magic Formula! To look at why, we need to go back to the very definition of what the Magic Formula is. “The magic formula tries to buy those companies that provide the best combination of being both cheap and good.” – Joel Greenblatt, The Little Book That Still Beats the Market , Afterword to the 2010 Edition As Joel Greenblatt said both in the book and in almost every interview since then, the Magic Formula is a thought experiment – what results would you get if you tried to buy stocks that were cheap, Benjamin Graham style, but also good, Warren Buffett style? As the Magic Formula is an abstract thought experiment, the parameters of “cheap” and “good” are both simplified. “Cheap” is taken to mean that a company, compared to other companies, trades at a price that is cheap price compared to its earnings. But instead of using the simple price to earnings ratio, Joel Greenblatt’s Magic Formula instead uses the adjusted metric of EBIT/Enterprise Value. “Good” is taken to mean that a company, compared to other companies, can reinvest its money at higher rates of return. The adjusted metric that the Magic Formula uses to calculate this is EBIT/(Net Working Capital + Net Fixed Assets). The Magic Formula ranks the stocks in the market by how cheap they are, ranks them by how good they are, and then combines these rankings to get an ordering of how cheap and good each stock is. Put even more simply, the Magic Formula is a way to systematically buy companies that are priced at less than they are worth. That’s value investing. The good thing about the Magic Formula is that it does this for you. Even better, you don’t actually have to run the screens yourself (although you can if you want to). Just go to magicformulainvesting.com /, create a free account, and the computer will spit out a list of stocks (US stocks excluding ADRs and financial and utilities stocks, for which it is not appropriate to use the Magic Formula criterion) for you. You then simply buy a few stocks from this list every month, and hold each stock for about a year (give or take a day for tax-loss harvesting). That’s how little work you need to put in this. Oh? And the returns…they’re quite good. In The Little Book That Still Beats the Market , Joel Greenblatt reported that the Magic Formula applied to stocks over $50 million from 1988 to 2009 returned a total of 23.8% annualized. By comparison, the S&P returned a total of 9.5% annualized over that same period. You can see the performance of the Magic Formula since then at third-party sites unconnected with Joel Greenblatt (so the methodology in calculating return – which is complex, may not be exactly the same). But this article won’t focus on the returns. If you want to research those, there are a lot of third-party sources that let you look into more details on that. This is an article on how to be a value investor by using the Magic Formula. And being a value investor is about having the correct process, not on chasing recent good performance. So if the Magic Formula is so great, why hasn’t everyone done it? What is it about the process that makes it so good, and yet so rare? And we all know that one of the iron rules of finance is that good ideas tend to be arbitraged away. Why hasn’t the Magic Formula suffered the same fate? A few reasons: 1. The stocks that the Magic Formula highlights tend to be cheap for obvious reasons. Many are heavily shorted and hated. Stocks that are cheap despite being quantitatively good tend to be so because of serious headline risk or other “ick” factors. 2. The Magic Formula works for the same reason that value investing itself works – that is to say, it doesn’t work all the time and it takes time, and in today’s impatient and recent-past-performance oriented market, this opportunity does not get fully arbitraged away. And the results are quite volatile. There will be many down months and in fact many down years and many months and years of underperformance as well. 3. The Magic Formula is robust, meaning that not only does the top ten percent of stocks as ranked by the Magic Formula outperform the other stocks, but the second best ten percent performs all the ones below it, the third best ten percent performs all the ones below it in turn, and so on, to the very worst ten percent. So it is naturally hard to arbitrage away. 4. It’s very unsexy. You won’t impress any of your friends by saying you beat the market by mechanically applying someone else’s formula from a book published in 2010. You won’t get a job in equity research or as a hedge fund analyst by talking about your personal portfolio which was invested mechanically in the Magic Formula. 5. And most importantly, going back to the original point – the very name of the Magic Formula is repellent to people! And the process is, too. People either want to use their judgment to pick stocks, or they want to just set and forget a regular monthly contribution to a fixed asset allocation across index funds. So the Magic Formula will never catch on. The whole thing has an ick factor. And that’s very beneficial to people who actually stick with it. The less people do it, the stronger it is. But although it works, you don’t hear a lot of stories of people getting rich with the Magic Formula. Why? The strongest reason is our human behavioral flaws. There’s something weird about the human tendency to ruin a good thing. Tobias Carlisle and Wesley Gray wrote about a strange phenomenon in their recent book Quantitative Value . Study after study in fields as different from finance as medical diagnosis have shown that even expert judgment tends to detract from the performance of a good model. That is to say, models do worse when you add human judgment, even if it’s the judgment of an expert! The same is true in investing, and especially so for the Magic Formula. Joel Greenblatt said it himself in an online column (referring to an experiment where a partner company set up accounts to let people either pick Magic Formula stocks themselves out of a defined list, or just do the picking for them, randomly): Well, as it turns out, the self-managed accounts, where clients could choose their own stocks from the pre-approved list and then follow (or not) our guidelines for trading the stocks at fixed intervals didn’t do too badly. A compilation of all self-managed accounts for the two year period showed a cumulative return of 59.4% after all expenses. Pretty darn good, right? Unfortunately, the S&P 500 during the same period was actually up 62.7%. “Hmmm….that’s interesting”, you say (or I’ll say it for you, it works either way), “so how did the ‘professionally managed’ accounts do during the same period?” Well, a compilation of all the “professionally managed” accounts earned 84.1% after all expenses over the same two years, beating the “self managed” by almost 25% (and the S&P by well over 20%). For just a two year period, that’s a huge difference! It’s especially huge since both “self-managed” and “professionally managed” chose investments from the same list of stocks and supposedly followed the same basic game plan. Let’s put it another way: on average the people who “self-managed” their accounts took a winning system and used their judgment to unintentionally eliminate all the outperformance and then some! – Joel Greenblatt, 2012 What tends to happen is this. The Magic Formula will give you a list of stocks to choose from. Most people will exercise their judgment and pick the stocks that look the safest or the most promising out of the list. They’ll purposely avoid the ugliest looking companies that they just know will lose money. And what will happen is that the stocks that tended to look the best will actually perform the worst, and the stocks that looked the worst will perform the best. And by doing so, they’ll drain all the outperformance out of the Magic Formula, and in fact end up not even performing as well as if they had simply bought an index fund! So I can say with certainty that you shouldn’t do that. I can give some personal examples out of my own Magic Formula portfolio. Chicago Bridge & Iron (NYSE: CBI ) looked like a great pick when I bought it in July 2014. (I exercised no judgment when I bought the stock. I bought it because it showed up on the relevant Magic Formula list for me.) It was a big holding at Berkshire Hathaway for good measure, picked either by Warren Buffett himself, or Ted Weschler or Todd Combs. One of those super stock pickers had decided this was a great stock to own. Even H. Kevin Byun of Denali Investors, one of Joel Greenblatt’s best students, was behind this stock! As of the writing of this article, it’s down over 30% from my cost basis, excluding dividends. And it could turn out to be a permanent impairment of capital, depending on what happens in the world. On the other hand, Ebix (NASDAQ: EBIX ) looked like a terrible pick when I bought it in August 2014 (Again, I exercised no discretion in picking the stock, but bought it merely because it showed up on the Magic Formula list.) The stock was extremely heavily shorted, and I think I had to put in a special verification code at my broker when buying it, so heavy was the stigma. As of the writing of this article, it’s up over 45% from my cost basis, excluding dividends, and could go higher still. A few tips for implementing the Magic Formula without style drift due to behavioral error: 1. Decide on a fixed asset allocation to the Magic Formula, and then stick with it, by putting the same dollar amount into the Magic Formula every month. Don’t chase returns by putting money in when the Magic Formula has done well in the last few months, and then not putting money in when the Magic Formula underperforms the market. Beware of self-deception in coming up with reasons not to stick to the exact rules. 2. Don’t time the market. Concretely, this means making your contributions regularly rather than according to your whim or any other market-timing factors. And it also means sticking to the rules of holding each stock for one year (give or take one day, for tax-loss harvesting purposes), no more, no less, regardless of how good or bad the stock looks at any given point of time during your holding period. 3. Pick stocks completely randomly from the Magic Formula list, and resist the urge to “just this once” selectively buy or not buy a stock, no matter how great your knowledge on that specific company. This goes back to the point expressed in Quantitative Value about even experts detracting rather than adding value to a good model, which is what the Magic Formula is. The last point is the most important, and the hardest to stick with. You will end up buying a lot of stocks that look like value traps, and a lot of those stocks will in fact be value traps. My portfolio currently has Gamestop (NYSE: GME ), among other companies that everyone knows are obsolete, Herbalife (NYSE: HLF ), among other companies that everyone knows are “frauds” and King Digital Entertainment (NYSE: KING ), among other companies that everyone knows have past earnings that are unsustainable in the future. All of these stocks may in fact end up as losses. But implementing the Magic Formula means trusting that on the whole, taken across a diversified portfolio of Magic Formula stocks, and over a long period of time, because of the systematic underpricing by the market of these statistically cheap and good companies, the losers will be made up for by the winners. And because we trust in the power of a proven model over human judgment, which we know to be flawed, we know that throwing out or throwing in stocks to your Magic Formula portfolio will on the whole detract from the portfolio’s returns. The easiest way to fail, and ironically what happens to almost everyone who tries the Magic Formula, is that they just cannot stick with it in a systematic way (just Google “Magic Formula blog.” You’ll find many who a retail investor who tried to be a Magic Formula investor but just could not stick with it or ended up making their own little tweaks that killed their returns). In fact, the failure rate was so high that Joel Greenblatt – who doesn’t exactly need the money after making millions as a special situations hedge fund manager – opened a set of mutual funds called the Formula Funds that did the Magic Formula for you. But then that didn’t work out either because people could not handle the volatility. So then he closed those funds and opened a series of mutual funds called the Gotham Funds that do a sort of modified Magic Formula, but that short expensive stocks as well to lower the volatility. You can invest in those if you’d like. But to be honest, the fees are pretty high. And if you can handle volatility, you should just do the Magic Formula by yourself. After all, Joel Greenblatt keeps on paying the hosting fees for magicformulainvesting.com/, and keeps on standing by the Magic Formula in interviews. And if you want to hedge your market exposure, you can always just buy S&P 500 put options or futures. So although the secret is out, it’s as if it isn’t. After all, value investing itself hasn’t exactly been a secret for a very long time, and yet it continues to work. So if you are the rare person who can stick to the Magic Formula, you will end up beating the market over the long run. That’s what will happen if you buy stocks that are both cheaper than the market and better than the market. That’s what long-term value investing is. Sticking to a process that you know works. And the process here intuitively makes sense. By following the Magic Formula, you are basically making your own mini index fund. But it’s better than a typical market-capitalization-weighted index fund that you might buy from Vanguard. Instead of being weighted towards the biggest companies, which may be overpriced compared to their intrinsic value, your mini-index fund that is your Magic Formula asset allocation is equally weighted among a set of companies that are both the cheapest and the best. You can’t not do better than the market in the long run (although you will have months and years of underperformance which cause most people to quit, and thus which allow the anomaly to continue to exist) with such an approach. You are buying better businesses that are also cheaper. And if you believe in the principles of value investing, you know that the return from investing comes from a combination of the underlying businesses you buy and the prices you pay for them. So you will beat the market, and you will do it by value investing. Yet somehow, you can avoid doing any of the hard work usually involved. Just don’t talk about it to your friends, family, and on forums. You’ll be derided for using a “Magic Formula” and reading a “Little Book That Beats the Market.” But that’s good. It means less competition for you, and that’s why the Magic Formula will continue to be a compelling investment methodology going forward. P.S. One downside of using magicformulainvesting.com /, which is after all free, is that the site does not retain historical data. Thankfully, some third parties have stepped up that task. The best I’ve seen are www.magicdiligence.com /, which provides summaries of the Magic Formula’s performance each year since 2009, so you can see how the Magic Formula performed since the book’s publication, and www.dusthimer.net/Magic-Formula-Data.html , which has collected the monthly Magic Formula picks as reported by the website, so you can play around with the data yourself. But I personally don’t recommend playing around with the data too much here. You’ll get tempted to add a variable or ten and ruin a simple good thing, as most have. Additional disclosure: The author’s personal portfolio has a substantial portion allocated to a strictly mechanical Magic Formula strategy.

Spark Energy’s Income Statement Is In For Some Pain

I’m taking my losses and selling SPKE before Q4 earnings. SPKE has abandoned its plan to increase spending to acquire customers and has now doomed its income statement. SPKE’s model isn’t built for constant shifting between high and low spending and this will create many problems. In hindsight I always knew what Spark Energy (NASDAQ: SPKE ) was, and I detailed that in my initiation article, so maybe I shouldn’t be as disappointed in how this trade turned out as I am, because I’m actually really disappointed. I’m selling SPKE on Monday at the open down 14.5% or so (depending on where this stock opens) for a couple reasons but primarily because the company has no idea what it’s doing. It’s literally operating in an industry where all you have to do is spend endlessly to acquire customers (welcome to the S&M black hole!), pray that you can do a decent job at hedging exposure to natural gas (creating the spread that creates the margin), do a good enough job to hang on to the majority of customers (but trust that there will in fact be churn), hope the share price goes higher, raise debt or finance via equity offering, and repeat the process. The most important must-do by far of those listed is spend, by the way. That’s all you have to do. Heck, I’ll make it even simpler for you SPKE – use your new revolver, yeah the one with the $37.9 million in current borrowing availability and go acquire customers. It’s that easy. Just spend, spend, spend! What do you not get about that? (click to enlarge) But of course, SPKE management couldn’t do that. No, SPKE management just announced on the Q3 CC that it’s executing its third strategic shift in as many years. What is this shift I speak of? Well, I’m speaking of the shift to (again) lower customer acquisition spending (this is after ramping customer acquisition spending in mid-2013 after lowering it in early-2012) to focus on “the longer-term sustainable growth consistent with our focus on distributable cash flow (SOURCE: SPKE Q3 CC )”, whatever that means. I say whatever-that-means because there’s nothing “longer-term” about SPKE’s business. It’s a commodity of the worst variety, meaning it has zero differentiation from competitors and zero value-prop to customers other than at any given point it can offer electricity services at a cheaper price than its competitors, which is by definition the definition of a commoditized business. This is pretty well evidenced in the attrition SPKE experiences regularly. I mean consider this, SPKE spent to acquire 91,000 customers between Q2 and Q3 while at the same time 44,000 customers walked through the door on the way to the next commoditized provider: (click to enlarge) Talk about an inefficient model. Now getting back to the stated reduction in spending and focus shift, this becomes a big problem because every time SPKE drops customer acquisition spending, as they did in FY2012, SPKE sees its revenues fall off a cliff. I’ve detailed this in SPKE’s financials in previous articles and even promoted this as a reason that “value” existed in buying the shares when I did. Of course this was under the assumption that management would actually do what it said it was going to do at the time I bought shares, which was spend, spend, spend. I only bought these shares because I wanted to piggy back on the ramped spending and the fact that the spending costs (customer acquisition costs) get recorded as an asset on the balance sheet and accounted for through D&A over 8 quarters. I wanted to front-run the what should have been explosive top-line growth with what would have been for a while minimal D&A additions to the income statement. This would have artificially enhanced the income statement and I was hoping propped the stock to a point that I could have sold at a healthy gain all while collecting a fat dividend for waiting. Yeah, it didn’t exactly turn out as planned. So, here we are with today’s “new model” that SPKE is promoting as the way of the future. Forget that the company has a horrible looking S-1 filing with three years of volatile financials and that the company has zero history of being able to execute on any single strategic initiative for more than a quarter or two. Don’t mind that. Let’s just get long some shares because, well, this is the way of the future. This is the “longer-term” more “sustainable” way to run this commoditized business. I think SPKE thinks it’s something it’s not and that can be a very dangerous thing. It has been for bagholders in the past and has been for this bagholder through 5 five months of ownership. The Ramp UP and The Ramp DOWN SPKE’s creating huge financial volatility for itself by constantly ramping up and ramping down spending. It’s also creating volatility for itself in not having a focused approach to its S&M efforts. SPKE also noted on its Q3 CC that it’s shifting its focus again back to commercial accounts, something it had completely abandoned after focusing on several years ago. You see a pattern here? SPKE seems to always be chasing the “hot dot” of the moment and seems to be the real case of the tail wagging the dog. Take a look at what it’s done for the income statement: (click to enlarge) So, first things first SPKE’s 9M results are absolutely blown up because 1H/14 was blown up by spending not being ramped until Q3/13. Let me explain how that works. SPKE can easily track revenues growth with S&M spending growth. What it can show is that once it increases spending, roughly three months into elevated spend levels revenue growth begins to turn upward. After about six months revenue growth reaches a terminal velocity where more spend is needed to created more velocity. That’s a pretty easy equation to follow. Now, I don’t know if that is uniform in this space or not but that’s what SPKE’s history has shown us. When SPKE decided to increase S&M spend in Q3/13 that means Q1/14 was only seeing terminal velocity of the initial increases in spend levels (which were increased from there further) and in fact the spend was being spread across larger geographic areas. This means that velocity was lower across a wider casted net which means sales were lower than they could have been had SPKE simply been concentrated (further saturating an area with spend). Yet another misstep. Regardless, that explains the 9M results showing such a variance from the Q3 results. Oh, by the way, we’re heading back to the days of reduced spending but don’t worry things are going to be different this time around because management has a plan. The 9M/14 results show flat top-line results, better NAO revenues (which are basically hedging gains or losses and largely SPKE has shown it has zero control and/or predictability in this line item), much higher operating expenses, and growing operating and net losses. This is inclusive of the benefit of a lower D&A expense, which will slowly be getting bigger quarter after quarter for the next six quarters before shrinking assuming SPKE actually maintains its plan to lower spending. There’s a huge amount of customer acquisition costs that have to be D&A’d to the income statement from the previous quarters spending ramps, regardless of if SPKE abandons the strategy half way through. What drove the 9M and quarterly results? S&M spending and hedging. That’s the entire business here folks. There’s a guy knocking on your door or a flyer in your mail offering you electric service. Is it at a lower cost or not? That’s what drives SPKE’s income statement. It’s really not that complicated but somehow SPKE has found a way to complicate it. What’s really sad is that had SPKE just stayed the course it might have been able to finally hit a vein regionally that it had some traction with or find a market that actually responded to its spending. I mean the cash is already gone, why not actually use what’s left on the balance sheet and dip into the revolver? Everything outlined in red is bad. The entire income statement is bad. I mean just look at that net income destruction Y/Y from ~$12 million to ~$7 million. Now, I’ll give SPKE that it hadn’t had a full 9M to show its increased spending and larger customer base within the 9M/14 figure, and subsequently SPKE went out and acquired some customers from outside sources so at least it’s trying the M&A route, but the comps it was up against in 2014 weren’t tough considering it didn’t ramp 2013 spending until Q3 as well. I just don’t have any sympathy for SPKE’s financials at this point because it’s doing this to itself. SPKE’s Adjusted EBITDA really shows the customer acquisition cost spend differential and why I say that once you start spending in this model you have to continue to spend forever, that the model basically becomes a constant black hole of S&M dollars: (click to enlarge) You can see how I’ve outlined the massive difference in customer acquisition costs in the comparable periods. In Q3/14 it was roughly 400% Q3/13, you don’t think that should have been driving revenues? You don’t think the ramp from previous quarters should have been driving revenues? The fact that the Q3 income statement showed flat revenues Y/Y in Q3/14 is a clear sign that the ship is already starting to take on water. That ramped spending is about to start to really add up on the income statement over the next few quarters in the form of a D&A uptick and SPKE isn’t going to have the revenues to offset it. It’s going to be taking huge losses on that when it happens. The spending difference becomes pretty egregious on the 9M side of the Adjusted EBITDA. 9M/14 customer acquisition costs were roughly 700% 9M/13 spending. Even with that, even with the compounding spending that should have reached maximum velocity from quarter prior SPKE still posted flat revenues. What an absolute disaster. This is going to bury SPKE’s stock over the next few quarters and was something I outlined in my prior articles. If SPKE didn’t have consecutive and sequential blowout top-line growth quarters you want nothing to do with this company. It won’t have the top-line to make up for the D&A uptick. That in a nutshell explains the bear thesis around this name going forward. This stock is dead, it just doesn’t know it yet. Do I need to even note those Adjusted EBITDA figures? Didn’t think so. Now, you can imagine what these types of operations have done for cash flows, which actually account for the cash outflows of the customer acquisition costs as they are incurred: (click to enlarge) Yeah, the cash from operations has been blown up and maybe that’s the reason for the strategy shift towards lower spending. Maybe SPKE management saw that what they were doing (again) wasn’t working and decided that conserving the last of the cash and the last of the liquidity via the revolver was the primary concern. I mean to hell with the income statement, that’s just for accounting nerds, the cash flow statement is dealing in real dollars, actual cash and when you run out of that and still don’t have a plan on the board for how you turn the corner and make it to spring you don’t get to play anymore. Even at minimal levels of revenues if SPKE can get spending down low enough it can generate good levels of FCF. Just look at both of these periods listed here. Solid FCF could allow the company to rebuild its cash balances and make one more run at another strategy shift or whatever else the company might have in mind. The point is, just don’t run out of cash. I think that’s probably the best explanation I have for what’s been announced and what’s about to be allowed to happen to the incomes statement. Where’s the trade? The trade is to sell SPKE and don’t ever consider it on the long side again. This business model and this niche isn’t one that you want to invest in for all the reasons mentioned in the beginning of this article. It’s a commodity with no way to differentiate itself and no way to protect itself from the wide swings that come with trying to hedge energy exposure on a constantly fluctuating demand. SPKE always was a bad business but I thought I could catch a few cheap points riding an accounting loophole that would have allowed revenue to grow while expenses remained artificially low on the income statement. I was wrong and lesson learned. I recommend a sell of SPKE. I look forward to providing continuing coverage in the future. Good luck to all.