Cereal Killer

In late 2016, short-seller Eiad Asbahi was riding high. His tiny hedge fund, Prescience Point Capital Management, had zigzagged its way to an annualized return of nearly 29 percent since 2009. Asbahi cranked out thick research reports skewering roll-ups, China-based frauds, and other flawed businesses his fund bet against. He bested Warren Buffett by shorting Chicago Bridge & Iron Co., a construction company with questionable acquisition accounting that the Berkshire Hathaway chief executive was unwise enough to invest in. 

On the morning of November 9, however, Asbahi’s wagers went awry. With the surprise election of Donald Trump, it was clear financial regulation was going out the window. Suspect companies that Prescience Point was shorting like auto lender Credit Acceptance Corp., under investigation by authorities, soared in the weeks after the election. The fund lost 31 percent for 2016, its only calendar-year deficit.

“We were caught naked,” says Asbahi, 39, in his sumptuous office overlooking an upscale commercial strip in Baton Rouge, Louisiana. “Politics matter to the type of investing we do, and they can matter in a very big way.”

Asbahi did not pull in his horns. He continued to blast companies with searing research. The move has paid off: His fund is on a tear, up 41.3 percent net of fees year to date through October. 

Asbahi raised the stakes on April 26, unveiling Prescience Point’s highest-profile short campaign yet. He published a 39-page report on cereal juggernaut Kellogg Co., pointing out that several recent accounting and operational moves were artificially bolstering revenue, understating company debt, and padding operating margins.

Kellogg’s maneuvers are spelled out in the company’s financial filings, he notes. By extending payment terms for customers, Kellogg is encouraging them to buy more now than they normally would, Asbahi argues. Eventually the buyers will need to rein in their purchases. 

And Kellogg is also slowing its payments to suppliers, temporarily bolstering operating cash flow. Soon, it has to stop.

“We expect that they will have to pay the piper,” Asbahi says. “Accounting excesses always unwind.”

Prescience Point forecast that Kellogg shares, then trading at $60.95, would fall by more than a third to Asbahi’s target of $39.50.

Asbahi aired his pitch on Bloomberg Television. “The company is a lot less profitable, much more expensive, and much, much more highly indebted than the financial statements convey,” he said. “It won’t be able to meet its guidance targets, and it’s going to be forced to decide whether it wants to cut its dividend or maintain its credit rating.”

Kellogg stock dropped 7.1 percent over the next week, to $56.65. Shares then rebounded, climbing to $74.84 by mid-September. 

Asbahi was sanguine — in a September letter to investors, he wrote that the fund had doubled its short position when Kellogg’s share price hit $74. On October 31, Kellogg announced that higher expenses in part due to the rollout of single-serve Pringles and Cheez-Its, combined with higher shipping costs, would result in flat operating margins. It sharply lowered earnings guidance too. The stock fell 9 percent, to $65.48.

With his finely groomed two-day stubble, boyish looks, and chunky Patek Philippe watch, Asbahi is a throwback to an earlier hedge fund era. Although he is open to money from pensions and big institutions, he is loath to change his freewheeling style and distinctive organization. With just $40 million in assets, his fund can target companies small or large, U.S. or foreign. He can toggle between long and short. 

“We march to the beat of our own drummer,” he says, adding that he is happy to keep his fund lean and agile. 

Boutique fund managers often claim staying small can make for an attractive business model. “Outside money tends to pour into a fund after a winning streak and flee after some downdrafts,” says Jon Carnes, investment manager at Eos Holdings, who runs a short portfolio in Dubai. “A smaller, close-knit group of investors seeking long-term performance will tend to add more capital when performance is down and take profits after successful years.”

Idiosyncratic hedge funds like Prescience Point face challenges, however. “It is hard to scale these kinds of special-situation shorts,” says Charles Lee, a professor at the Stanford Graduate School of Business and former global head of equity research at Barclays Global Investors. “Institutional investors are unlikely to be interested in investing in them.”

Accordingly, gathering and keeping the right clientele can determine a fund’s success. That becomes its own hurdle. “Your client has to figure out how to fit this into their portfolio,” Lee says. “You need to have investors who buy into your approach.”

Asbahi cultivates his. Many are Baton Rouge area locals, ranging from financial advisers — like Thompson Creek Wealth Advisors CEO Lance Paddock, whom he met at the local Rotary Club — to landscapers like Kevin Clement. “My investors understand that volatility is necessary for the generation of superior long-term returns,” Asbahi says.

After the 2016 drawdown, he phoned each of them, explaining the loss. “I told him, ‘You don’t owe me this phone call’,” says Cyndie Baker, an optometrist who has invested in Prescience Point since 2013. “You have to let people do their jobs the way they let me do mine.” She added to her investment in Prescience Point after the call.

The payoff for Asbahi is that he is doing something a lot of hedge fund managers don’t get to do — pretty much whatever he wants.

Eiad Salahi Asbahi was born in bucolic Denham Springs (estimated 2017 population: 9,834), outside Baton Rouge, beside the turgid Mississippi River. 

Asbahi’s father, an immigrant from Syria, was the only pediatrician in Denham Springs. His mother was a bookkeeper. 

Growing up, Asbahi was set on following his father into medicine. “I looked up to and wanted to be like my father,” Asbahi says.

Aside from reading, he had no hobbies and didn’t play sports.  “I was a nerd,” he says.

Asbahi graduated from Denham Springs High School in 1997, a valedictorian.

From there it was on to Louisiana State University, 20 miles away. Summa cum laude, with a 3.96 grade point average and a BS in microbiology, Asbahi was a shoe-in for the LSU School of Medicine. 

Then, in his first semester, Asbahi realized blood made him somewhat squeamish — and that he would not become a doctor.

Asbahi returned home. “It was a big family ordeal,” he says.

The grad school dropout worked as a barista at CC’s Coffee House and as a waiter — and opened a TD Ameritrade account. Something clicked. 

“I spent my time wondering what made stocks move,” he says. Soon Asbahi entered LSU’s MBA program. “I was the hungriest guy in the room,” he says. “I wanted to learn this game.”

After graduating at the top of his class in 2006, Asbahi headed to New York with a spreadsheet of more than a thousand hedge fund manager names to badger for work. 

SAC Capital Advisors gave him a take-home test, analyzing Life Time Fitness, the exercise chain. Asbahi modeled the numbers out for 30 years. He didn’t get the job.

Markets were on fire and funds hungry for talent. Asbahi landed an analyst position at Sand Spring Capital, a small fund with connections to Baton Rouge that had offices in Short Hills, New Jersey, a center for distressed debt investing. 

At Sand Spring, under former bankruptcy attorney Kevin Miller, Asbahi learned to invest across a company’s capital structure. Miller taught him how to examine subordinated debt covenants, bank loans, and equity. “You’ve got to look at these companies 360 degrees,” Asbahi says.  

Sand Spring launched a fund soon after Asbahi joined in 2006. Ill-advisedly, the fund bought mortgage- and asset-backed securities, blowing up in 2008. Wiser, Asbahi was soon unemployed.

In the maw of the crisis, funds fired analysts in droves. Asbahi deftly marketed himself as a consultant. Funds could pay him for the work he did rather than a fixed salary. “I was extremely hungry and willing to do anything,” Asbahi says. “I had great mentorships.”

At Cohanzick Management, he focused on high-yield, distressed debt and special-situation stocks. Asbahi was well-liked — and eager to soak up knowledge. “I’m tickled pink,” says Cohanzick founder David Sherman. “I’m glad he feels he learned from us.” 

At Kinderhook Partners, Asbahi analyzed small companies, targeting cheap growth stocks that could benefit from catalysts. Managing partner Tushar Shah recalls him pushing Kinderhook to buy jet-plane-backed bonds, arguing the planes were solid collateral. (Asbahi does not remember the bonds.) The securities soared in price.

“He’s fearless,” says Shah. “He’s willing to go against the grain. That fit in well with us.”

Asbahi left Kinderhook in early 2009 and began managing Prescience Point in August, returning to his beloved Baton Rouge. “Louisiana is my happiest place,” Asbahi says. “My family and friends drew me back.”

As a short-seller, Asbahi belongs to a dwindling tribe. As stocks have surged for nearly a decade, the number of short-bias funds has plummeted to just 12 in September from 54 in 2008, according to Hedge Fund Research.  Assets have tumbled by half to $3.8 billion from $7.8 billion. 

In such an environment, scrappy Prescience Point — it consists of just Asbahi and two analysts — has not only survived but thrived.  

On a rainy October morning, Asbahi tooled around his cathedral-ceilinged, 2,500-foot man cave. There were dramatic black curtains, an 85-inch TV, a kitchen stocked with yogurt and almonds, and a queen-size bed — where Asbahi sleeps during frequent multiday research binges. The room was punctuated with potted ferns in marble planters and sculptures themed upon ancient Greek statuary. Shelves contained books by Benjamin Graham and Dale Carnegie, among others.  

At 5 feet 8 inches tall and a slim 155 pounds, Asbahi’s youthful looks could win him a lead in a boy band. He’s affable yet cagey, even by the standards of hedge funds’ secretive milieu. 

The white “idea” walls, covered with glossy IdeaPaint to scribble on with a marker, were wiped clean before this writer’s visit. 

Asbahi won’t disclose whether his fund is net long or net short, or the names of his analysts, for security reasons. Nor will he talk specifics about a short trade, whether he borrows stock or uses options to place his bets. “We look at all available tools and will effect a trade accordingly,” he says.

Flexibility is key in this opportunistic profession. In its early years, Prescience Point tapped into a lucrative vein for short-sellers: fraudulent Chinese stocks. After the financial crisis, a stream of dubious China-based companies popped up on U.S. and Canadian stock exchanges, providing targets for short-sellers savvy enough to nail them as frauds. 

Often, these companies would scoop up Chinese assets and float their own shares or those of a tenuous affiliate in North America. Hapless U.S. investors would buy them. 

The businesses these companies claimed to own in U.S. filings often bore little resemblance to what they did in reality. Asbahi worked with China-based investigators to debunk frauds, spending hours scouring documents and data. An early target was A-Power Energy Generation Systems, based in Shenyang. 

A-Power Energy’s predecessor began as a simple blank-check company — a shell enterprise funded with cash, whose purpose is finding business assets to buy. The goal in this case was to purchase a Chinese manufacturer for $30 million and float the shares in the U.S. The company bought a tiny Chinese maker of off-grid electrical equipment in 2008, changed its name to A-Power Energy, and listed its stock on the Nasdaq Stock Market.

Asbahi’s case against the company, detailed in a June 2011 report when shares traded at $2.25, had multiple threads — opaque related-party transactions, seemingly nonexistent customers. 

But the most damning evidence appeared in black and white: In SEC filings, A-Power Energy reported 2009 operating income of $38.24 million on revenue of $311.25 million. Filings for the same year with China’s State Administration for Industry and Commerce (SAIC) showed an operating loss of $2.68 million on revenue of just $25.66 million. Cash, assets, and shareholder equity were far lower in the SAIC filings too. “The business is materially much smaller than is reported in SEC filings,” the report read.

Shares, already falling, dropped precipitously. Shortly after the Prescience Point report, A-Power Energy’s auditor resigned, and Nasdaq soon announced the delisting of the company’s shares at 27 cents. 

Asbahi moved on to other China companies that year. Around this time, trolls began harassing and threatening him online.

“When you’re going to war with criminals, it can get pretty ugly,” says Asbahi, who subsequently bought a house in a gated community. He lives with his wife and 18-month-old daughter.

Helped by his China shorts, Prescience Point notched a gain of 69 percent in 2011, which he followed with four straight profitable years in a bull market. “Every year, he was able to put together some opportunities that he could profit from,” says Thompson Creek Wealth Advisors' Paddock. 

Soon, Asbahi was hunting questionable accounting closer to home. For years, he had watched as Baton Rouge–based Shaw Group grew from a small pipe fabricator into a builder of power plants and other big projects. By 2012, he was familiar enough with the company’s nuclear plant construction to suspect there might be trouble when Chicago Bridge & Iron agreed to buy Shaw in a $3 billion merger.  

Firms like Shaw and Chicago Bridge & Iron are risky because they generally guarantee the final cost of their projects, leaving them on the hook if something goes awry. To an acquirer, that can be toxic baggage.

And Chicago Bridge & Iron was making a big purchase — something Asbahi had learned to eye with skepticism. “One of the red flags we look for is whether the company is raising the level of acquisitions from year to year,” he says. “We had expertise in analyzing roll-ups.”

The deal closed in early 2013 with fanfare. Within months, Berkshire Hathaway disclosed a 6.5 million share stake in Chicago Bridge and Iron. By year-end, in conference calls Chicago Bridge & Iron CEO Philip Asherman was praising efficiencies fostered by the merger and waxing about the “seamless” transition. 

Chicago Bridge & Iron reported 2013 full-year results on February 25, 2014. The company weighed in with adjusted earnings per share of $4.91, or 17 percent above analyst consensus. Ebitda was $960 million and gross margins were 10.8 percent. Shares rose 3.2 percent.

Asbahi was concerned with another number, however: cash flow from operations, which came in at a stunning negative $112.8 million. It was the first time Chicago Bridge & Iron had ever posted negative cash flow from operations, but few others noticed. Yet it occurred in the same quarter that the company had reported its highest earnings.

Asbahi spelled out his thesis in a 38-page Prescience Point research report published that June. Specifically, Chicago Bridge & Iron had used the purchase to build up an estimated $1.56 billion in reserves. 

“It’s like magic,” Asbahi says. “With acquisition accounting, companies can inflate their earnings in any number of ways.”

The company was directing those reserves into gross profits to cover losses resulting from what Asbahi believed was Shaw’s hemorrhaging nuclear power plant contracts. “They set up a cookie jar,” he says.

By Asbahi’s calculations, 2013 adjusted earnings per share were inflated by 52 percent, Ebitda by 36 percent, and gross margins by 27 percent. Instead of beating analysts’ consensus earnings-per-share estimate by 17 percent, Asbahi calculates Chicago Bridge & Iron would have missed it by 22 percent without the bolstering from reserves.

“The message was loud and clear,” Asbahi wrote. “The Shaw acquisition had gone very wrong.”

In his report, Asbahi forecast shares, trading at $73.48, would fall to $37.38. Chicago Bridge & Iron agreed to be acquired by McDermott International last year for the equivalent of $17.30 per share, with no premium to its then-current share price.

Buffett, at one time Chicago Bridge & Iron’s largest shareholder, had long since bailed, having sold the last of his shares in the fourth quarter of 2015.

“My reaction at the time was, ‘How could Warren Buffett miss this?’” says Asbahi.

As the face-off with Buffett shows, Asbahi has no trouble going against consensus. Short-sellers, he says, often display herdlike characteristics and hold positions too long. Prescience Point on occasion profits by buying shares in heavily shorted stocks whose dynamics, unbeknownst to rivals, have changed.

One example is Hawaiian Holdings, the parent of Hawaiian Airlines, which Prescience Point began buying in late 2013 and was the most heavily shorted U.S. airline stock at the time. “There was an absolute, fundamental misunderstanding of the company,” Asbahi says.

As a destination carrier, Hawaiian Airlines had a clear edge over competitors. Its infrastructure was concentrated in Honolulu, giving it a cost advantage over rivals, who maintained expensive U.S. hub-and-spoke systems. Hawaiian Airlines also had a virtual monopoly on flights between the islands, helping it maintain a roughly 26 percent market share versus its continental-U.S.-based rivals on travel to and from the islands. 

What was weighing on shares was a massive capital program embarked upon three years earlier. Hawaiian Airlines was buying new Airbus A330s, building infrastructure, and starting new routes to far-flung cities across the Pacific — among them Brisbane, Beijing, Sydney, and Auckland. 

It was an expensive gambit, resulting in a surge in net growth capex from $291 million in 2012 to what Asbahi estimated to be $323 million in 2013 and $422 million in 2014.  

Accordingly, the stock was widely shunned, trading at just 8.8 times estimated 2014 earnings, versus an average of 13.7 times for U.S. competitors and 16.6 times for Asia Pacific carriers.  

Asbahi, however, projected that with the Airbus purchases winding down and expensive route expansions kicking in, net growth capex was set to decline — to $246 million in 2015 and just $148 million in 2016.

That meant adjusted Ebitda margins — “artificially compressed,” in Asbahi’s argot — were poised to soar, from an estimated 11.8 percent of revenue in 2014 to 17.2 percent in 2016. Net income would jump from an estimated $79.2 million in 2014 to $174.3 million in 2016. 

Hawaiian shares, trading at $10.20 in February 2014, more than doubled, finishing the year at $26.05.  

Prescience Point’s campaign against Kellogg brings its short-selling to a new level. Asbahi is facing off against such American mass media icons as Pop-Tarts, Fruit Loops, and Tony the Tiger. 

Asbahi was first interested in turnover in Kellogg’s executive suite. Former CEO John Bryant, in his early 50s, stepped down from that position last year after ushering in accounting and other changes. Former CFO Ron Dissinger had left the company just before. 

Short-sellers and activists have been circling packaged food companies, including Campbell Soup Co. and Kraft Heinz Co., as the public turns away from salt, sugar, and processed foods. 

Kellogg's results have held up better than most. Earlier this year, Asbahi launched what he calls a “forensic” analysis of accounting over the past ten years at the Battle Creek, Michigan giant. Asbahi and colleagues interviewed 20 or more former employees, suppliers, and industry experts about changes at the business, and drilled into filings and footnotes.

Prescience Point’s conclusion: Kellogg’s results were due to “an unsustainable accounting charade.” 

According to Prescience Point, the company pulled $1 billion of revenue forward, for example, by offering extended payment terms to customers. That encouraged them to fill their warehouses with Kellogg’s goods, stuffing their inventory channels today at the expense of future sales.

Kellogg also entered into reverse factoring agreements that allowed suppliers to sell the company’s payment obligations to third-party banks. That let Kellogg delay payments to suppliers, Asbahi says, bolstering operating cash flow.  

The cereal maker has been selling its accounts receivables, which conceals the impact of the extended payment terms on cash flow and the balance sheet. Nonoperating pension gains and added-back recurring restructuring charges goosed operating margins.

Asbahi says it is likely not a coincidence that executive pay at Kellogg is tied to the very metrics most affected by the company’s accounting legerdemain — operating profit margins, cash flow, and revenues.

The result: Adjusted sales for 2017 were overstated by 2 percent, operating margins by 3.2 percentage points, and adjusted operating cash flow by 23.7 percent.

The company’s new CEO, Steve Cahillane, will be forced to choose eventually between a dividend cut and a credit downgrade by rating agencies, Asbahi says. The Prescience Point research report argues that shares could fall some 35 percent.

Asbahi figures that Cahillane has already missed the opportunity to start his tenure with a clean slate and will be forced to continue what the short-seller calls “shenanigans” — until the CEO eventually bites the bullet and suffers the consequences.

Kellogg declined to comment on Prescience Point’s report. But at the company’s annual meeting in April, one attendee asked Cahillane about it.

“Is that a bunch of baloney?” he asked. 

“It’s a short-seller,” Cahillane responded. “I'd encourage you to just think about motivations.”

The big question is whether Asbahi’s analysis will trigger a reassessment by management — and the Wall Street analysts who cover Kellogg. “It’s systematic,” says Asbahi. “They blow off our research.”

In August, for example, Morningstar sector director Erin Lash raised her fair-value estimate for Kellogg to $81 from $74. She maintained the $81 estimate after Kellogg, as Asbahi had predicted, lowered its earnings forecast. Lash lauded the company’s increased investment in single-serve Pringles and Cheez-Its. 

Asbahi counts himself skeptical and doesn’t think expenditures on single-serve products are the real reason for the shortfall, instead blaming years of accounting gimmickry. On November 12, Kellogg announced a new restructuring — and put its fruit-snacks and cookies businesses on the block, including Keebler and Famous Amos. Asbahi says the planned sale is an alternative to a rating or dividend cut. 

“They are trying to raise cash,” he says. “Things will get worse before they get better.”