Description

I recommend the short sale of Escala Group (“ESCL” or “Escala” or the “Company”).  ESCL is a battleground stock, pitting short sellers against short-term speculators who have recently shown the ability to move the stock around by large percentages.  The Company appears to have been involved, whether consciously or unconsciously, in helping Afinsa Bienes Tangibles (“Afinsa)” its Spanish majority owner and significant customer, perpetrate an alleged massive fraud on the Spanish public, which may have resulted in the loss of hundreds of millions of dollars.

The Company issued a press release last week declaring that an internal investigation had found no evidence of collusion in the alleged Afinsa fraud by ESCL management, causing the stock to rise by over 80% since the close on December 18.   

My short thesis is two-fold: (1) given the circumstances surrounding the alleged Afinsa fraud, it is unlikely that the Company is free of all liability; and (2) ESCL is significantly overvalued, given the financial status of the Company since it has shut down its Afinsa business.

My most significant short-term concern is the continued risk of a short squeeze, with a very high ratio of the float currently sold short; my suggestion to mitigate this risk is to limit the position to a very small part of your portfolio.  This position, though likely volatile in the short term, should work out nicely over the medium term.

I currently have a short position in ESCL, but this may change at any time.  I was able to borrow the stock this morning.

BACKGROUND

Escala Group, formerly known as Greg Manning Auctions, Inc., is a global integrated network of companies in the collectibles market with operations in North America, Europe and Asia as well as on the Internet. The Company operates through three sales platforms: auctions, merchant/dealer operations and trading; and in two segments: collectibles and trading.  Approximately 67% of the company’s stock is owned by Afinsa.

Afinsa and another Spanish company called Forum Filatelico offered stamp “investing” to the Spanish public, raising $6 billion from 140,000 Spaniards over 25 years for guaranteed rates of return as high as 8% compared to 3.5% paid on Spanish government bonds.  An investor’s money was supposedly used to purchase stamps, and investors retained the option to sell the stamps back to Afinsa after one year at a price to reflect the guaranteed rates of return, or to reinvest the money to compound the guaranteed investment rate.  Most people seemed to reinvest their money.  Critics argued that the stamps underlying the liabilities were worth far less than the liabilities, and that money from new investors was being used to pay off old investors, a classic Ponzi scheme.

In 2003 Afinsa acquired approximately 70% of Escala in return for the Company becoming the primary supplier of Afinsa’s coins and stamps. The original deal called for Afinsa to buy $250 million worth of collectibles over five years, but it renegotiated the contract to buy $1 billion worth over 10 years.  The gross margins on these “related party” sales from Escala to Afinsa were far larger than the gross margins on non-related party sales, raising suspicions that Afinsa was trying to inflate the value of the Escala shares it owned by artificially boosting its profitability.

In May 2006, Spanish authorities raided Forum Filatelico and Afinsa, and nine people suspected of possible criminal offenses were arrested. Spanish police alleged that the stamp investments the companies were offering were Ponzi schemes. The government raided 21 homes and offices and found some 10 million euros in cash during one of the searches. It also froze the companies' Spanish businesses until a court-appointed administrator could step in to run them. Escala’s stock declined over 80%% from $32 to $5 over a few days following the news.  

Subsequently,

(1)     ESCL shut down its business of selling stamps to Afinsa

(2)     ESCL CEO Jose Miguel Herrero, former CEO and founder Greg Manning, and past CFO Larry Crawford resigned

(3)     ESCL announced that the SEC was formally investigating the company

(4)     ESCL delayed filing its 10-K for the year ended June 30, 2006 and its 10Q for the quarter ended September 30, 2006

Fast forward to Tuesday last week, when many investors were expecting the company to be delisted at any time by NASDAQ for failing to file its financial statements.   Before the open, Escala issued a press release that its internal investigation had found that a material restatement of its historical financials was necessary (including classifying a significant portion of its related party sales as additional paid-in capital), but a special board committee had “found no evidence that the Company had attempted either to defraud Afinsa or to collude with Afinsa in attempting to defraud Afinsa's customers or the Company's investors”.

Since ESCL’s entire float is sold short, a short squeeze developed over the next several days.  In the five trading days beginning last Tuesday, ESCL’s shares, which closed on Monday at $4.48, traded as high as $13.30.  The float is approximately 9 million shares; the trading volume over the five days has totaled over 75 million shares.

POTENTIAL SOURCES OF LIABILITY FOR ESCL

In 2005, gross margins for sales to Afinsa were approximately 52.3%, compared to 7.8% for non-related party sales.  This makes it hard to argue that ESCL management was unaware that something was wrong.  The restatement related to the Afinsa sales confirms this.  It would be logical for the Spanish government to try to recover the “excess profits” earned by ESCL from Afinsa (and therefore Afinsa’s customers, the Spanish public).

Annual sales by ESCL to Afinsa were approximately $100 million, approximately the size of the entire U.S. stamp market; this implies that there were few market tests on the pricing applied to Afinsa purchases.

The Afinsa relationship is not the only instance of alleged wrongdoing at ESCL.  According to other news sources, Spectrum Numismatics, another Escala affiliate, is at the center of its own fraud scandal over coin deals made with the Ohio Bureau of Worker's Compensation, in which the central figure has already been jailed.

                    ESCL’s 8K filing last week stated that  “No present or former employee of the Company declined to cooperate with the investigation. 

However, certain other persons did decline to be interviewed, and the Audit Committee was unable to compel these individuals to provide information. 

Further, persons providing information to the Audit Committee did not do so under oath.”  This implies that the internal investigation clearing ESCL 

of fraud may have been incomplete, particularly given the recent resignations of three of ESCL’s top officers.

ANALYSIS

For calculation of the pro forma numbers, I have eliminated the related party business and reduced operating expenses by 33%.

On March 31, 2006, ESCL had net cash of $17 million.  According to their last press release, ESCL had overstated sales (and by implication, profits) by $73 million over the last three years.  With the generous assumption that ESCL gets a tax refund of $22 million (@ a tax rate of 19%), spends $10 million on investigations and legal defense and runs at breakeven going forward, pro forma net cash would be $29 million.

With an enterprise value of $216 million, ESCL trades at EV/EBITDA = 50x.

Catalyst