Bio-On: A House of Cards? Welcome to Trade Ideas. I'm Jake Merl, sitting down Gabriel Grego, Quintessential Capital Management. Gabriel, great to have you on the show for your very first Real Vision interview. I'm delighted to be here. So today, we'll be talking about a company called Bio-On, which is actually a bio plastics company based in Italy. You published a report at the end of July and you basically called the company a house of cards. The stock fell 75 percent immediately after you published the report, the stock was suspended from trading, it's currently trading around 60-70 percent below from when you conditionally published the report. So break it all down for us. How do you look at companies? What's your methodology for shorting stocks? What specifically led you to Bio-On? The methodology in general is pretty clear. So what I'd like to do is I try to pick my battles well. In other words, I don't go after social situation, but look for extreme circumstances, which usually means some kind of a catastrophic, but hidden situation inside a company. It can be a fraud, it can be crime, it can be dishonest management, it can be completely failing business model, but in a hidden way. So that's the first phase. We have a bunch of ways in order to receive ideas and deal closed. For example, out of funds, we do our own proprietary research, our screening mechanisms. So once you go over the first screen, the second screening is to try and understand exactly what's going on. Come up with a rational thesis of the underlying problem of the company, and then collect a critical mass of information that not only explains in depth what's going on, but also can can prove the thesis beyond reasonable doubt so to speak. The final phase is to find a way to communicate our findings with the wider public with the market in a way that is both understandable, clear, and very viable. That's also very important. So we want the average reader or the average person who watches are our thesis to be able to reverse engineer at least some of the most critical point of the thesis so that it can convince themselves of the exactness of the thesis basically. So what this typically lead you to Bio-On? Bio-On is a stock that many funds have been looking at in the last year or so, a lot of short funds, some of them are well known. They had large short positions. Persistent short positions sometime increasing short positions. So it was definitely on our watch list, and we started looking at a company, and the first one we saw what we believe are glaring accounting anomalies of the type that we see in the companies that usually interests us for one reason or another. For example, huge discrepancy between cash flow generation and earnings. For example, sales that for the most parts are never or almost never cash stands for the sales and huge receivables, and then we saw what was a pattern of press releases and communication to the investors they are in a reason in our opinion were at least a little bit exaggerated. So the company claimed to produce certain variety of its product the company that's plastics, plastic that is contributing to the cure of cancer, plastic that can clean the oceans, plastic that can replace metal, a plastic that can replace human bones, and many other. I am not going to list all of them, but a lot of them strikes us as very unlikely, and finally, all we did is going and analyzing these communication from the very beginning, from before the IPO all the way till today, and we tried to see what happened after their communication, and we saw them very often this project were announced together with huge investments in plans and large purchases of technology, but then if you go see during the years, most of them, the overwhelming majority of them nothing ever happens. So if it's about collaboration with some auto industrial reality, the factory never gets built, in some cases, the licenses which is technology transfer don't really get paid, if they get paid, they get paid in something that looks to us quite strange. Like essentially using some of Bio-On own cash in order to pay itself, and so on, and so forth. The next thing we did is we came up with a thesis, and then we sought out people in the industry that could give us like European and what was going on. We spoke to for example CEOs of other companies that are in the same or similar industries, we spoke to some scientists, and we hired accountants and auditors to go through their accounts and try to make sure whether our impression of redeposited account we're actually validated by a professional, and I would say with very few exception everybody corroborated our fears. So it turns out that the accounting is showing some serious irregularities that a lot of the people that we spoke to question some of the declaration of the company, some of the technology application. So overall we believe our thesis was valid data, and once we saw a critical mass of validation, we decided to a share with the market and with the public our findings. So based on the analysis you've done, are you saying the company has poor management and maybe that technology isn't quite as what they say or are you saying the company's in actual fraud and the stock price is worth zero dollars? We never use the word fraud every time we are doing our reports, but this is only for legal reasons. What we like to do is to share all the most important findings with the public maybe with our opinion as to what could be going on underneath, but we prefer not to give real judgments, we like the public to given the judgments. So come to your own conclusion, but basically what we saw is a company that in 12 years of operations and several years as a public company has never traded any free cash flow. Is a company that at the very least until the end of 2018 has never sold anything or produced anything of substance outside of its network of shell companies. In other words, they do show some sales, but these sales tend to be to companies which are affiliated or related to themselves. So the game that they do is they seek out some partner. There usually a real company sometime with a good reputation, and they form a JV. This JV is actually short company, and the terms change from company to company, but the idea is well, we're going to start research into this application for Bio plastic or narrow replication, and at some point will be at a factory. We commit large amounts of capital to the factory, and right away this entity buys that technology from Bio. Now, a few things happen. Number 1, the people we spoke to and the auditors looked at the accounts say that the price at which it these licenses were sold, the amount that has been determined have been irregular because in Italy, every time you're selling an asset to a company that you your self-control or is affiliated to you, you cannot just give it an arbitrary value, but you need to get a official appraiser. Nominated by the Courthouse, which basically comes out with a business plan and evaluation based on this business plan, which then checks it over time to make sure that the asset is performing according to expectations, in fact. Now, what seems to happen is that this exercise was not done or at least we didn't find any evidence with does exercise being done so we cannot trust the amount that was paid for this technology transfer. Their mother that was sold, but in many cases, it was never paid. In other words, a company sells technology to these entities, which are sometimes 50 percent owned by the company itself, sometimes 90 percent owned by the company itself, but then the payment never occurs or almost never occurs. In the few cases where some money did go back in, what happened? Bio-on made what looks like a capital injection into the vehicle, and then used the capital injection of money to paid cell back from the license. So this is the type of thing that we saw, and these companies themselves, these joint ventures that we call them shell companies, they have Bio-on administrators and their actors. The offices are located inside Bio-on so they don't seem to have any dedicated employees. They don't have any sales of their own. They don't have any production of their own, at least not in 2018. So this $50 million almost never occurs into cash. In 2019, the simplest started a little bit of production, but it's really minimal amounts. So obviously, you're pessimistic on the company, but the stock price today is actually up 20 percent or so on news that a Russian company might be using some of their technology. What do you make of that? Well, today's company is non-use for anybody that has been following what's going on. So they announced this joint venture with a Russian company at least back in February this year. So there is nothing new about it. All they did today is saying that, that project has gone to the subsequent phase of implementation without really defining what is this implementation. It was not clear to us who exactly is going to pay for this factory that they want to build. It wasn't clear to us why would a Russian company whose core business is hydrocarbons be interested in producing plastics, especially since Russia is not a particularly environmentally-sensitive country. So to us, this is the usual modus operandi. In other words, you go and seek out partners and you open with them a joint venture, you announce a big project, and if the past is history, nothing concrete will turn out on these things. So you've been short stock for quite some time and you've obviously done quite well, but how do you suggest traders currently play the setup? How have you already taken profits or do you think there's more room to run on the downside? We still have a position open in the company. The reason why we're highly skeptical and we think that may be more downside has to do with the financial situation of the company. So the financial health of a company is a function of liquidity and solvency. So as far as liquidity, the company lost in 2018 something like €21 million. So it's actually negative free cash flow and has a pretty high burn rate. Some of these euros was capped back, but even if you take out the cap, it is still burning a lot of cash. So liquidity is negative. What about solvency? So what's the balance sheet? On the asset side, you have receivables about 44 percent of the assets. These receivables, who's the party to that? These joint ventures which are related to Bio-on, and they themselves don't seem to have enough financial solidity. They don't have production of their own, they're not generating any cash. So how exactly are they going to repay these payables? Some of them are very old, even 40 years old. So we don't trust this 40 percent, we don't believe that annual [inaudible] or at least most of it will generate cash eventually. The rest is the factory, the only factory that they managed to build, and it's a really tiny factory of 1,000 tons or production per year, which sounds a lot, but we're talking about plastic. We made a financial analysis. We don't think that this factory can produce economically. They're producing what is pretty much a commodity, it's a protocol PHA, it's a type of bioplastic. They're not the only producer of this bioplastic, there are many around the world, and it usually wholesales for something like four, five, six dollars per kilo. So the company claims that it's doing a particular type use for cosmetics which might sell for more, we believe it when we see it. So with those numbers that factory cannot be economical, can only lose cash, therefore, should be written off, should not be considered an asset. The rest, only about five percent of the assets, is just technology. This technology has been purchased for modest amounts. It's not significant relative to the size of the balance sheet, and a lot of scientists we spoke to, they had a lot of objection and skepticism on these patents, and are almost worthless. So that is the case, the asset side of the balance sheet is not worth very much. They have some cash. They had some cash at the beginning of 2019 about €20 million, which can give them some breathing time, but what's on the other side? You have large amounts of bank debts and large amount of account payables. In other words, money that they owe to their suppliers and to the companies that built the factory, and a large amount of this liability have to be settled by the end of the year. Right now, they don't have enough resources to settle. So either they raise cash with the share issue or somehow they get a refinancing. We are very skeptical on the possibility of doing either at reasonable terms. That's why we think there may be a lot more downside. Of course, in cases like this sometime the regulators jumps in and terminates the party. So in terms of the actual stock price, how low do you see shares actually going? It's very hard to come up with a target price. Usually, when we intervene, you can see it our track record in a large percentage of cases that stock goes to zero and the company gets obliterated. We're not saying that this is necessarily the case here that could happen or could not, but I'd certainly think there is a more than a zero percent chance that this happens. What would you say is the biggest risks to your short thesis? What could go wrong that could actually lift the share price higher? Well, I mean you can come up with very remote scenarios. So I just received this sometime, for example, somebody may offer to buy the company, maybe because they haven't done enough due diligence, or maybe because they just want to be in the headlines for buying something that is considered green technology, that's a possibility. For some miracle, one of their joint ventures might actually start producing and generating real money, something that we haven't seen so far except for a minimal amounts, and finally, headline risks like we saw today, for example, the demands to pull out another press release, which in our opinion didn't say very much about the price reacted in a very bullish way. So all of these will probably be temporary price spikes. We see there is a very low chance and long-term that this is a good investment. These are our opinion, of course, we don't have a crystal ball. So would you have a stop-loss just in case any of those things do play out? We don't believe in stop-loss very much. We usually analyze the situation and we update our view of the situation based on whatever new information we gets and we make rational assessments. If we believe that all of a sudden the intrinsic value changed, then we may change our mind. But honestly, my gut feeling is that's not going to happen here. Since because the stock is already down so much in just the past few months, what's the short interests look like right now? Is it expensive to borrow shares and to short the stock? I checked a few days later. So short interest has been already high and has been increasing. Most of the short interest is accounted by four large funds. Most of these funds, if not all of them, have been slightly increasing their position ever since we published, which we find very heartening because it means that they probably share our thesis. The boar was very expensive. Something like 40 percent per year. So I would say anybody that would be interested in replicating the trade to make sure that they managed to have like a nice exit plan and not to plan there to be there indefinitely because again a boar is expensive. Gabriel, that was great. Thanks so much for joining us. It was great having you on the show. You're most welcome.