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10th annual new york

value investing congress

September 9, 2014 New York, NY

Lessons From a Dozen Years of Short Selling
Whitney Tilson, Kase Capital
Lessons From a Dozen Years of Short Selling

Whitney Tilson
Value Investing Congress New York
September 9, 2014
Kase Capital Management
Is a Registered Investment Advisor
Carnegie Hall Tower
152 West 57th Street, 46th Floor
New York, NY 10019
(212) 277-5606



12 Reasons Not to Short (1)
(Excerpt from Chapter 11 of More Mortgage Meltdown)
Shorting looked easy in 2008, but in reality it's a brutally tough business. In many ways, it appears
to involve nothing more than applying the same analyses one uses when determining whether to buy
a stock: on the long side, investors generally seek companies with good management, strong growth,
high margins and returns on capital, little or no debt, clean balance sheets, and sustainable
competitive advantages all at a low price. Conversely, short sellers look for weak or dishonest
management, low or negative growth, margins and returns on capital, high and increasing debt,
accounts receivable and inventory, and weak competitive advantages all at a ridiculously high price.
But shorting is not simply the opposite of long investing. It's much harder and more dangerous for
a number of reasons:
1. Your upside is capped and your downside is unlimited precisely the opposite of long positions. When
shorting stocks, you could be right 80% of the time, but the losses from the 20% of the time that you're wrong
could exceed the accumulated profits. Worse yet, a once-a-century storm such as the internet bubble might
wipe you out entirely. If there's even a 1% annual risk of such an event, that tiny risk translates into a 39.5%
chance of the freak event occurring over 50 years.
2. To prevent such an occurrence, most short sellers use stop loss limits, meaning they will start covering the
short if it runs against them a certain amount. This means short sellers not only have to be right about a stock,
but also about the timing. If a stock rises significantly, many short sellers will lock in losses, even if they are
later proven correct.
3. In order to short a stock, you first must get the borrow from your broker, who has the power to call in the stock
you've borrowed at any time or, worse yet, buy stock to cover for you. Brokers are most likely to do these
things if the stock is rising quickly, and they're probably doing it to other short sellers as well at the same time,
so all of this buying pressure can cause a stock to rise even further, triggering even more covering. This
vicious cycle is called a "short squeeze" and it isn't pretty we can show you the scars on our backs.
4. Shorting has gotten much more competitive. There are now a few thousand hedge funds (and who knows how
many individual investors) looking for the same handful of good shorts, in contrast to a few dozen a couple of
decades ago. This results in "crowded" shorts, increasing the odds of a short squeeze.
12 Reasons Not to Short (2)
(Excerpt from Chapter 11 of More Mortgage Meltdown)
5. A short squeeze can also be created if the "float" the number of shares that trade freely is suddenly reduced.
Such a case occurred in October 2008 when Porsche, which owned 35% of Volkswagen, unexpectedly disclosed
that it had raised its stake in Volkswagen to 74.1% through the use of derivatives. The German state of Lower
Saxony, where Volkswagen is based, owns 20%, so that left a float of only about 5% of VW shares on the market.
Three popular hedge fund trades had been to short VW based on weakening car demand, go long Porsche and
short out its ownership of VW to "create" only Porsche, or go long VW preferred stock and short the common stock,
betting on relative underperformance of the common. In any case, for whatever reason, nearly 13% of all VW
common shares were short, so moments after Porsche announced its higher stake, the mother of all short
squeezes ensued and the stock instantly quintupled from $200 to over $1,000, momentarily making VW the most
valuable company in the world. This was extraordinarily painful for many shorts.
6. Short sellers used to earn interest on the cash they held while they were short a stock, but this has all but
disappeared due to low interest rates and brokers even charge "negative rebates" on hard-to-borrow stocks,
meaning that short sellers have to pay 5%, 10%, 15% or more in annual interest to get the borrow.
7. The long-term upward trend of the market works against you (yes, believe it or not, markets used to go up most of
the time).
8. Gains are taxed at the highest, short-term rate.
9. It generally requires many more investment decisions, thereby increasing the chances of making a serious mistake.
10. It's a short-term, high-stress, trading-oriented style of investing that requires constant oversight.
11. Mistakes hurt your portfolio more as they compound. If you make a mistake with a long position, it becomes a
smaller percentage of your portfolio as it drops. A mistaken short, however, grows larger as it appreciates.
12. If you go public with your short thesis, a company can attack you in many ways: file a lawsuit (Fairfax), complain to
regulators (who occasionally investigate) (MBIA, Farmer Mac), tap your phone (Allied Capital), etc. Also, expect to
get flamed on message boards and in the media. Many people view short selling as evil and un-American.
Conclusion (in 3/09): "we'll again repeat that, especially in this environment,
for most people, we think shorting stocks is a very bad idea."
Carnage in the Short Sector Today
Viewing shorting as insurance is fine as long as it's cheap
But it hasn't been cheap while there was some relief in April and May,
overall there's been carnage in the short sector since the market bottom
exactly 5 year ago on March 9, 2009
2013 was especially bad a once-every-10-to-20-year storm
Some short-only funds have closed
Some hedge funds have launched long-only funds
Many hedge funds have reduced their short exposure, often
What Short Sellers Were Saying
During the Melt-Up of 2013
"Being bearish in the bull market has been, thus far, a mug's game and
a hedge against profits." Doug Kass
"We've also taken our lumps this year on the short side (and since
March 9, 2009) so we know how you feel. For what it's worth, we agree
that this is the best environment to find shorts and we are seeing some
incredible opportunities. We haven't seen a variance like this between
our longs and shorts since early 2008. So, while I feel like I'm covered
in battle wounds and have blood dripping out of my eye balls at the end
of each day, I am confident we will be rewarded for staying the course."
A friend
"I don't have the antidote to your pain. We've been bludgeoned by this
melt-up as well. It's unbelievably unpleasant. I've never seen such
widespread capitulation among seasoned short sellers. Many are out of
business. This stretch is worse than the internet bubble for me. It's
constant pain across my entire short book, whereas the internet was
isolated to one industry and then you got relief when the bubble
burst." Another friend

Nine Reasons to Short (1)
1. If you're very good at it, you can make money over time.
2. Having a short book allows me to invest more aggressively on the long
side, both in terms of overall portfolio positioning, individual position
sizes, and willingness to take risks in certain stocks. Here are some
I wouldn't be comfortable taking my fund's long exposure up to 100% in the
current market if it didn't have meaningful short exposure;
I wouldn't have held onto my position in Netflix as it's risen from just above
$50 to nearly $500 over the past two years if my fund wasn't short a
number of similarly volatile, speculative stocks;
I wouldn't hold such a large position in Howard Hughes, another huge
winner for us, if my fund weren't short St. Joe, which is also closely tied to
the real estate/housing market; and
I'm not sure I would feel comfortable owning economically sensitive stocks
like Tetragon (my newest long), Avis and Hertz, four airline stocks, etc. if
my fund weren't short many stocks that I expect would do very poorly if the
economy weakens.
Nine Reasons to Short (2)
3. A short book typically pays off just when you need it most, during
severe market declines, providing cash and the psychological boost
to invest aggressively on the long side when it's most attractive. It also
stems investor redemptions, which is effectively another source of
This is exactly what happened to me in 2008 and early 2009. After inflicting
losses as the market rose from early 2003 through October 2007 (the same
length of time as the current bull market), my substantial short book
cushioned the downturn my fund was down approximately half the market
in 2008 and allowed me to invest aggressively on the long side, which
translated into big gains after the market bottomed in March 2009.
4. I sleep better at night with insurance. At the beginning of every year, I
write a check for homeowner's insurance and at the end of the year,
when my apartment hasn't suffered from a flood or fire, my insurance
expires worthless and I have to buy it again. Is it a mistake to buy
insurance that turns out to be worthless almost every year? Of course
Nine Reasons to Short (3)
5. The psychic rewards are enormous:
Shorting is much more contrarian than buying an out-of-favor stock
Its incredibly interesting and entertaining thanks to the preposterous lies
and incredible cast of characters you encounter shysters, crooks,
charlatans, promoters, etc.
It feels good to bet against these cretins
For all these reasons, making $1 on the short side is 5-10x more gratifying
than making $1 on the long side
6. Developing the mindset of a short seller has been very valuable:
extreme skepticism, knowing where to look for bombs on a balance
sheet, etc.
7. It puts me in the flow of short ideas, so I often hear/read about
problems with companies whose stocks Im long (or considering going
long), which has saved me from some blowups/value traps.
8. It keeps me occupied so I dont do stupid things with my long book like
sell a winner or get impatient and sell a stock right before it jumps.
9. Most investors expect hedge funds to have a short book.
Summary: I Have Conflicting
Thoughts on Shorting Right Now
I have two strong feelings about shorting right now:
1. It's a horrible business, it's cost me (and my investors) a fortune over the past 5 years, I
wish I'd never heard of it, and every bone in my body wants to cover every stock I'm short
and never short another stock again; and
2. In my 15+ years of professional investing, the only other times that have been as target-
rich in terms of juicy, obvious shorts are late 1999/early 2000 and late 2007/early 2008
(and we all know how those ended). My bottoms-up research is uncovering a great new
short idea every day, but only one great new long idea every month
So which feeling am I going to follow? I don't know, but this I know for sure: the only
other time I felt like covering every short and becoming a long-only manager was
October 2007. At that time, I went through my short book, stock by stock, and said,
"OK, am I willing to cover MBIA at $70? Hell no, not a single share! Allied Capital at
$30? Hell no, not a single share! Farmer Mac at $30? Hell no, not a single share!"
And on it went I couldn't bring myself to cover a single share of any stock I was
short they were all "trembling-with-greed" shorts.
And that's exactly how I feel today. I look at the stocks I'm short all of which I think
are absurdly overvalued and sure to collapse and feel intensely that covering them
now would be the most boneheaded capitulation trade of all time.
That said, unlike in 2007, I don't have the same foreboding feeling that there's a
good chance that the world will fall apart in the next year or two (though it's
possible), which makes being short that much harder
Sources of Good Short Ideas
Other short sellers
Cultivate relationships, build networks, swap ideas
Attend investing conferences
Value Investing Congress
Value Investing Seminar (Italy)
Robin Hood Investors Conference
Ira Sohn Conference
Value Investor Insight
Can access ideas as a guest with a 30-day delay
Activist Shorts Research (www.activistshorts.com)
Seeking Alpha
Stock screens
Newspapers, magazines, business television
Lesson: Be Diversified and Try to
Match Long and Short Positions
Be diversified
Until a year ago, I was managing my short book like I manage my long book, but
half the position size; thus, on the long side I had 12-15 5-6% positions and on
the short side I had a dozen positions averaging 2.5%
I learned the hard way that a 2.5% short position is, in most cases, too large; if
such a position goes parabolic, as some have done, it's very painful and forces
you to cover to manage risk
Today I have ~50 positions averaging ~1%
Try to match long and short positions
There's a serious mismatch between a long book focused on large-cap blue-chips
like Berkshire Hathaway, AIG, Procter & Gamble, Microsoft, and ExxonMobil (I
own the first two), and a short book focused on smaller, more volatile, heavily
shorted, battleground stocks
These stocks tend to be the most overvalued and have the potential to fall the
furthest often, I believe, 100% but they can also rise the most during periods
of excess liquidity and complacency (like today)
Owning riskier (and heavily shorted) stocks like Netflix, magicJack, Sodastream
and Deckers (sold earlier this year) can balance the pain on the short side
If you have a large-cap, low-beta long book, look for shorts like IBM
Stocks Usually Follow Earnings
Even the most well-publicized, airtight case that a company is, for example, committing
blatant accounting fraud, bilking its customers, is dangerously underreserved and
overlevered, etc. is usually not enough to cause the stock to decline materially
As long as a company continues to report growing earnings, its generally safe to
assume that its stock will continue to rise as well
Historical Examples: Allied Capital (David Einhorn) and MBIA (Bill Ackman)
Bill Ackman published a devastating 66-page report on 12/9/02 entitled Is MBIA Triple A? and
in subsequent years he continued to warn investors, ratings agencies and regulators about the
company and the danger it was causing to the financial system
But nobody cared as long as the company continued to report strong earnings, so the stock
doubled until the financial system collapsed, as did MBIAs earnings and stock price

Ackman publishes
Is MBIA Triple A?
Ackman warned
about comes to
pass five
years later!
Stock doubles
Be careful of companies successfully playing the "beat n' raise game"
Every quarter they beat their earnings estimates and raise guidance
There is no price a stock can't go to, especially if it's a high-quality business
Examples (none of which I'm short): LinkedIn, Facebook, TripAdvisor and Priceline
Beware of the "Beat N' Raise" Game
LinkedIn Facebook
TripAdvisor Priceline
Be Patient
Be patient
I've been reasonably successful over the years in being able to identify hugely
overvalued stocks, but have been less successful in getting the timing right
In such cases, I correctly foresee what's going to happen in a year or two, but
highly promotional management, as always cheered on by Wall St., dupes
investors into ignoring huge red flags and the stocks run up a lot in the short
I've certainly gained a greater appreciation for the power of short-term stock price
momentum and am going to make more of an effort to be patient, stay out of the
way of freight trains on the way up, and do what the best short sellers do: make
money by adding to shorts that are working on the way down
Lehman Brothers
Look for Titanics
Titanics are stocks that I believe have suffered major (even mortal)
wounds, but the market hasnt figured it out yet so the band is still playing
Examples: I think its likely that K12 and Neustar are the process of losing
contracts that account for ~25% and ~80% of EBITDA
Numerous regulators are investigating Herbalife and World Acceptance,
neither of which can withstand scrutiny I believe
World Acceptance
Look for Obvious Bubbles (1)
Examples: 3D Printing & Alternative Power
There's always room for obvious bubbles
But size them small!
3D Systems
Ballard Power
Look for Obvious Bubbles (2)
Examples: SaaS & Biotech/Pharma
Arena Pharmaceuticals
Raptor Pharmaceutical
Castlight Health
Look for third-tier, me-too players
Shorting is a very difficult business
Size positions small
Balance long and short book
Be patient
Stocks tend to follow earnings not analysis or headlines
Often there is time to get into a short after the writing is on the wall
Short stock rather than use options
Look for multiple ways to win
Very high valuation far above historical and peer averages
Very high margins far above historical and peer averages, and what
common sense says is possible
A fad coming to an end
Market under-reacts to an earnings miss/guide down, regulatory action, etc.
Impact of new competitors
Regulatory problems
An Update of Two Past Favorite Short Ideas
And My Current Favorite
Update on K12 (LRN)
Presented at the Value Investing Congress
on September 17, 2013
(the entire presentation is posted at:
Like subprime lending and for-profit colleges, the business makes sense on a small scale but,
fueled by lax regulation and easy government money, the sector, led by K12, has run amok
Presented on 9/17/13
Summary of Why I'm Short K12's Stock
K12's aggressive student recruitment has led to dismal academic results by students
and sky-high dropout rates, in some cases more than 50% annually
I wouldn't be short K12 if it were carefully targeting students who were likely to benefit from its
schools typically those who have a high degree of self-motivation and strong parental
But K12 instead appears to be doing the opposite; numerous former employees say that K12 accepts
pretty much any student and may even be targeting at-risk students, who are least likely to succeed in
an online school
There have been so many regulatory issues and accusations of malfeasance that I'm
convinced the problems are endemic
Enrollment violations, uncertified teachers, illegally siphoning profits from nonprofit entities
States (and the IRS) are waking up to what K12 is doing and the company is coming
under increased scrutiny, which is beginning to impair K12's growth and I believe
this trend will accelerate
K12's founder, Knowledge Universe, distributed its entire stake to its investors earlier
this month
Yet the stock, trading at nearly 50x trailing earnings, is priced as if K12 will continue to
grow at high rates for the foreseeable future and also improve on its persistently low
margins and free cash flow
Presented on 9/17/13
Conclusions and Catalysts
K12 is pursuing a growth-at-any-cost strategy that is harming countless students,
likely violating numerous state laws and regulations, and wasting hundreds of
millions of dollars of taxpayer money every year.
What the company is doing is becoming increasingly well-known so states and
possibly the IRS are waking up and thus the company faces increased scrutiny
and regulatory risk
The likely result is that K12 will not only miss its growth projections (analysts
project that K12's revenues and profits will grow 16% and 32%, respectively, in the
next year), but will actually have to shrink substantially in order to properly serve
students (and states/taxpayers)
Possible short-term catalyst: the company could disappoint when it issues FY
2014 guidance in mid-October and/or when it reports Q1 '14 earnings in early
November because:
Growth has been slowing
Preliminary enrollment data at a few schools are weak
Analysts seem to be factoring in rising margins and continued growth in
revenue per student, both of which I think are unlikely
Trading at nearly 50x trailing earnings, K12's stock is priced for
perfection, yet its future is likely to be far from perfect
K12's Stock Has Been Cut In Half
Since My Presentation
Source: BigCharts.com.
K12 Since My Presentation
K12s Academic Results Trail Those of the
Connections, Second-Largest Cyber School Operator
Source: Maine Connections Academy Virtual Charter School Application, 12/2/13.
K12s Academic Results Trail Those of the
Connections, Second-Largest Cyber School Operator
Source: Maine Connections Academy Virtual Charter School Application, 12/2/13.
K12s Academic Results Trail Those of the
Connections, Second-Largest Cyber School Operator
Source: Maine Connections Academy Virtual Charter School Application, 12/2/13.
K12s Academic Results Trail Those of the
Connections, Second-Largest Cyber School Operator
Source: Maine Connections Academy Virtual Charter School Application, 12/2/13.
Due to Poor Academic Results, K12 Is Being
Forced to Hire More Teachers, Which Will Hurt
Margins Going Forward
Question (Q4 conference call, 8/14/14):
The things that you talked about providing more teachers, more hybrid learning
environment, that all sounds all like a growth in market opportunity and improves
outcome. It also continues to be margin profile. So could you just comment on kind
of the impact on the cost side from those things?
Nate Davis, K12s Chairman & CEO:
I do believe that it will increase cost in the coming fiscal year. Its right
investment we think to make. Its primarily focused on student outcome more than
it is market opportunity. Its really the student outcomes were focused on. So
yeah, I think that teachers cost money and to the extent that we add teachers, we
will incur some of that cost.
it will change our cost structure a bit and well have a little hard cost on the
structure side.
We believe its really important to make sure that we give every effort to
making sure that students have right teacher support and getting the right
academic support, because that keeps school open, that keeps boards happy and
thats what keeps us in business. So this is the critical investment we have to
K12 Is Facing Major Difficulties in
Numerous States
The Agora Cyber Charter School in PA appears to be in the process of
cutting its ties to K12
If this happens, though it would likely take place over time, it would be a huge
blow to K12 as Agora accounts for ~13% and ~25% of the company's total
revenues and EBITDA, respectively (due to ridiculous over-funding of cyber
charters in PA)
It also portends potential similar activism by other boards of K12-affiliated
schools around the country
The Tennessee Commissioner of Education prevented the Tennessee
Virtual Academy from enrolling any new students after July 10
and could
close the school entirely
K12 is also having severe difficulties in Colorado, translating into lower
No Doubt Due to Scrutiny, K12 Claims Its Sending
Unengaged Students Back to Traditional Schools
Nate Davis, K12s Chairman & CEO, Q4 conference call, 8/14/14:
All of the headwinds I just mentioned, are all on top of our school boards and
K12 itself, pushing to keep business enrolled only if they're truly engaged and
ready to learn. We help students in every way we can, but if they are not
engaged, we often to shift back into structure that traditional brick-and-mortar
school and those withdrawals hurt enrollment as well.
Competition Is Increasing
Nate Davis, K12s Chairman & CEO, Q4 conference call, 8/14/14:
But I do see a transition in education to more hybrid model and more
traditional school districts offering online summer courses, online supplemental
programs and full-time district run online programs.
In the past, if you were family speaking of virtual education option for your
son and daughter, the only choice you had was a full-time managed program like
the ones K12 manages.
Today there are more public schools and districts that offer summer online
courses, in-season electives online, supplementary skilled specific online
programs and full-time programs run by the public school district itself. The
number of online options is broader and we believe that the overall demand for
virtual choice is increasing.
As I mentioned earlier, K12 through our institutional group, FuelEd, is
participating in this market shift and we are seeing increase in the interest of our
services we offer. However, in the short-term, these market dynamics create a
challenge to enrolling school students in the public schools.
When Asked About Future Growth, K12s
CEO Was Noncommittal
Nate Davis, K12s Chairman & CEO, Q4 conference call, 8/14/14:
its too early to predict with any certainty our total enrollments for the
2014/2015 school year. There have been a number of -- there have been a few
developments which are creating some headwinds and challenges to enrollment
we want to share with you these events and challenges were facing to help
you understand the growth trend, risk taking for upcoming years.
Over a multiple years, I would say, yes, we expect them to grow. The
volume of growth is something that is very difficult for us to project. As, we go
through the season, were learning more. We learned that in the bigger, older,
more higher penetrated states, were going to get less growth. In the newer
states, we get more growth. The offset for those I really cant -- I really cant tell
you at this point but -- do I expect some positive growth? I do expect it, but I just
cant say how much?
Why Im Still Short K12: The Growth Story
Is Over, Yet the Stock Remains Expensive
The company is facing major difficulties in numerous states and could
lose the bulk of a contract that provides ~25% of EBITDA
Of the four new schools opened this fall, three are very small Insight
schools (100-200 students each)
Academic outcomes continue to be poor
Increased scrutiny is forcing K12 to both tighten recruiting (hurting
enrollment and revenue growth) and spend heavily to hire more teachers,
etc. (hurting margins)
A former employee, a National Account Manager named Andrew
Ehrenfeld, has filed a lawsuit claiming that he discovered and reported
that K12 was diverting and directing students intending to enroll in public
school district-operated independent study programs into the K12-
operated public charter schools. As a result, California public education
institutions lost state education tax funding based on student Average
Daily Attendance to K12.
If true, this could impact K12s Institutional Sales business
The stock remains richly valued at 36x trailing EPS and 21x NTM
estimates (though only 6.3x and 4.6x trailing and NTM EBITDA)
Update on Lumber Liquidators (LL)
Presented at the Robin Hood Investors Conference on
November 22, 2013
(the entire presentation is posted at:
Presented on 11/22/13
Summary: There Are Many Ways to Win
The valuation is very high far above historical and peer averages
Operating margin is at an all-time high, roughly double the historical
The raid by federal authorities could impact the company in many ways:
LL might have to change many of its suppliers, which could raise product costs
and disrupt its supply chain
It could suck up significant time and attention of management
Legal/compliance costs might be large, both up front and ongoing
LL might get hit with a big financial penalty and/or other actions such as
charges against management
The EIA report might get picked up by the media and/or social networking,
which could impact sales and put additional pressure on the company
LL may have a formaldehyde problem, which could gain traction thanks to
a class action lawsuit that was just filed
A major new direct competitor, Floor & Decor, has emerged and is growing
Customer dissatisfaction appears to be extremely high, which could impact
future growth
Lumber Liquidators' Stock Has Been
Cut In Half Since My Presentation
Source: BigCharts.com.
LL Since My Presentation
Why Im Still Short LL: I Think There Are More
Shoes to Drop, Yet the Stock Remains Expensive
A dismal Q2 earnings report
Same store sales declined 7.1%, gross margin down 0.9%, operating margin
declined from 12.9% to 10.3%, net income down 19%
Guidance was even weaker:
CEO Robert Lynch:
"Customer traffic to our stores was significantly weaker than we expected,
particularly in geographic areas severely impacted by the unusually harsh weather in
the first quarter. The improvement in customer demand we experienced beginning in
mid-March did not carry into May, and June weakened further. Our reduced
customer traffic has coincided with certain weak macroeconomic trends related to
residential remodeling, including existing home sales, which have generally been
lower in 2014 than the corresponding periods in 2013. We now believe the
prolonged purchase cycle associated with our customers' discretionary, large-ticket
home improvement projects is likely to be delayed for some customers into the fall
flooring season, and for others, into spring of 2015.
a number of the factors weighing on our second quarter results are likely to
continue in the second half of 2014While we believe the third quarter may be
weaker than we originally anticipated, we have a strong sense of urgency and we
expect to regain traction to deliver operating margin expansion in the second half
and in coming years.
The stock remains richly valued at 22x trailing and 19x NTM EPS
estimates and 12x and 10x trailing and NTM EBITDA
My Current Favorite Short Idea:
Exact Sciences (EXAS)
Note: I credit this investment idea and
some of the analysis herein to Bios
Research (support@biosres.com)
Overview of Exact Sciences
Exact Sciences is a molecular diagnostics company focused on the early detection
and prevention of colorectal cancer
It has developed a noninvasive DNA screening test, Cologuard, which was
approved by the FDA last month, that detects colorectal cancer and precancerous
I prefer to short the stocks of fraudulent and/or evil companies, but thats not the
case here. I obviously hope Cologuard helps reduce the death toll from this terrible
disease I just dont think its likely to (certainly not to the extent thats reflected in
the share price)

Exact Sciences Stock Has Doubled in the Past Year
And Has Risen Nearly 60x Since Its 2008 Lows
Source: BigCharts.com.
Exact Sciences Since Its IPO
Colon Cancer Is the Second-Leading U.S.
Cancer Killer
The most preventable, yet least prevented cancer. Journal of the
National Cancer Institute
Source: Exact Sciences annual meeting presentation, 7/22/14.
Early Detection Is Critical
* Other studies show 74% and 6%, respectively.
Source: Exact Sciences annual meeting presentation, 7/22/14.
Yet Current Screening Is Poor
Only 65% of people who should be screened are, a major reason why
60% of colon cancers detected are already in late stage
Source: Exact Sciences annual meeting presentation, 7/22/14.
Current Screening Involves Three Steps
The Centers for Disease Control and Prevention recommend the following
screening tests and intervals for average-risk men and women ages 50-75:
1. Every year: High-sensitivity fecal occult blood test (FOBT) [aka FIT (Fecal
Immunochemical Test)], which checks for hidden blood in three consecutive stool samples;
2. Every five years: Flexible sigmoidoscopy, where physicians use a flexible, lighted tube
(sigmoidoscope) to look at the interior walls of the rectum and part of the colon; and
3. Every 10 years: Colonoscopy, where physicians use a flexible, lighted tube (colonoscope)
to look at the interior walls of the rectum and the entire colon. During this procedure,
samples of tissue may be collected for closer examination, or polyps may be removed.
Colonoscopies can be used as screening tests or as follow-up diagnostic tools when the
results of another screening test are positive.
Colonoscopy also is used as a diagnostic test when a person has symptoms, and it can be used as
a follow-up test when the results of another colorectal cancer screening test are unclear or
The main problem is the colonoscopy
Its time-consuming, invasive, not available everywhere, risks complications, expensive and
uncomfortable both the preparation as well as the actual procedure

* FIT (fecal immunochemical test), sometimes identified as iFOBT (immunochemical fecal occult blood test), is an improved FOBT with higher sensitivity and
specificity when compared to guaiac FOBT (or gFOBT). When used yearly, FIT has accuracy rates near those of colonoscopy (www.getthefitfacts.com).
Source: CDC.gov.
Comedian Dave Barrys Description of
Preparing for a Colonoscopy
Then, on the day before my colonoscopy, I began my preparation. In accordance with my
instructions, I didn't eat any solid food that day; all I had was chicken broth, which is basically
water, only with less flavor. Then, in the evening, I took the MoviPrep. You mix two packets of
powder together in a one-liter plastic jug, then you fill it with lukewarm water. (For those
unfamiliar with the metric system, a liter is about 32 gallons.) Then you have to drink the whole
jug. This takes about an hour, because MoviPrep tastes -- and here I am being kind -- like a
mixture of goat spit and urinal cleanser, with just a hint of lemon.
The instructions for MoviPrep, clearly written by somebody with a great sense of humor, state
that after you drink it, ''a loose watery bowel movement may result.'' This is kind of like saying
that after you jump off your roof, you may experience contact with the ground.
MoviPrep is a nuclear laxative. I don't want to be too graphic, here, but: Have you ever seen a
space shuttle launch? This is pretty much the MoviPrep experience, with you as the shuttle.
There are times when you wish the commode had a seat belt. You spend several hours pretty
much confined to the bathroom, spurting violently. You eliminate everything. And then, when you
figure you must be totally empty, you have to drink another liter of MoviPrep, at which point, as
far as I can tell, your bowels travel into the future and start eliminating food that you have not
even eaten yet.
After an action-packed evening, I finally got to sleep. The next morning my wife drove me to
the clinic. I was very nervous. Not only was I worried about the procedure, but I had been
experiencing occasional return bouts of MoviPrep spurtage. I was thinking, ''What if I spurt on
Andy?'' How do you apologize to a friend for something like that? Flowers would not be enough.
Dave Barry, Miami Herald, 2/22/08
Does This Look Like Fun?
Cologuard Is an Alternative to the Current
Screening Test, FIT
The Centers for Disease Control and Prevention recommend the following
screening tests and intervals for average-risk men and women ages 50-75:
1. Every year: High-sensitivity fecal occult blood test (FOBT) [aka FIT (Fecal
Immunochemical Test)], which checks for hidden blood in three consecutive stool samples;
2. Every five years: Flexible sigmoidoscopy, where physicians use a flexible, lighted tube
(sigmoidoscope) to look at the interior walls of the rectum and part of the colon; and
3. Every 10 years: Colonoscopy, where physicians use a flexible, lighted tube (colonoscope)
to look at the interior walls of the rectum and the entire colon. During this procedure,
samples of tissue may be collected for closer examination, or polyps may be removed.
Colonoscopies can be used as screening tests or as follow-up diagnostic tools when the
results of another screening test are positive.
Colonoscopy also is used as a diagnostic test when a person has symptoms, and it can be used as
a follow-up test when the results of another colorectal cancer screening test are unclear or

* FIT (fecal immunochemical test), sometimes identified as iFOBT (immunochemical fecal occult blood test), is an improved FOBT with higher sensitivity and
specificity when compared to guaiac FOBT (or gFOBT). When used yearly, FIT has accuracy rates near those of colonoscopy (www.getthefitfacts.com).
Source: CDC.gov.
Cologuard vs. the Current Screening Test
In a ~10,000 patient study published in the New England Journal of
Medicine, Cologuard was significantly more likely to detect colorectal
cancer and precancerous polyps vs. the current blood-based test, FIT:
Source: Exact Sciences annual meeting presentation, 7/22/14.
The Study Isnt As Conclusive As It Appears
A Bogus Comparison
The comparison FIT used in the Deep-C (Cologuard) study was an
inferior Polymedco FIT test, which uses a single stool sample (typically
only used by physicians when they want immediate results, such as in
the ER or in their office after a prostate exam)
A more fair, real-world study would have used a leading FIT test such
as InSure, which is done in the home (as is Cologuard), which uses two
stool samples and has an 87% detection rate
The CDC recommends a FIT test with three consecutive stool
samples, done annually; in contrast, Cologuard uses a single sample
and will likely be given only once every three years (the testing interval
hasnt been determined yet)
A study of Cologuard once every three years vs. a two- or three-stool-
sample FIT test once a year for three years hasnt been done, so its not
clear whether, in a real-world setting, Cologuard is superior to FIT
The Study Isnt As Conclusive As It Appears
A False Positive Problem
Unmentioned in Exact Sciences investor presentation is the fact that
Cologuard has a false positive rate of 13.4%, five to ten times that of the
InSure FIT test (~2%) and nearly three times the 5% rate of the inferior
Polymedco test used in the DeeP-C study
I think this will prove to be a deal killer for most doctors because it
means that for every 7-8 patients for whom they prescribe the
Cologuard test, the results come back with a false positive
This means the doctor has to call the patient and say, I have some bad
news: the test you just took indicates that you have colorectal cancer,
the second-deadliest form of cancer. But it might be a false positive, so
lets schedule a colonoscopy to be sure
The patient, of course, only hears the first sentence and panics, thinking
I HAVE CANCER AND IM GOING TO DIE!!! and has to endure true
agony and terror until they can get a colonoscopy and learn that,
Ooops, the test was wrong and youre fine
There Are Many Reasons Why I Think
Cologuard Will Be a Bust
Per the previous slide, its not clear that, in real-world practice, Cologuard
is any better in detecting colorectal cancer and is certainly worse in
terms of false positives than the FIT test
FIT has been around for decades and is widely known, trusted, available,
inexpensive and covered by all insurers
The average cost of FIT before insurance is ~$22 vs. 15-27x higher for
Cologuard (reimbursement has yet to be determined, but estimates are
~$325-$375; the list price is $599)
Cologuard is much messier
Major competition is looming
Reimbursement may be below the companys guidance
Commercial payors may be slow to approve Cologuard
Cologuards Ick Factor
Cologuard requires significantly more fecal handling than FIT, which
could lead to significant resistance by patients
FIT requires nothing more than a
quick poke of the stool:

In contrast, Cologuard requires
patients to fill an entire cup with
feces, a smelly, messy, difficult
and disgusting process:
Do you really think Americans
(and their doctors) will embrace
this poop-in-a-cup model???
Two earlier versions of the Cologuard test were busts
Peak quarterly revenues of <$250,000 and ~700 tests a decade ago
Competition Is Looming
An oral diagnostic (a camera-in-a-pill called PillCam Colon, made by Given
Imaging, which was acquired by Covidien earlier this year) was approved the FDA
in February (and was already available in more than 80 countries)
A blood-based diagnostic (Epi proColon Assay) is approved Europe and in the
approval process in the U.S.
Clinical Genomics of Australia has also developed a blood-based test focused on
two biomarkers of non-Sereptin9 methylated gene products
Other blood-based diagnostics with materially better sensitivity for pre-cancerous
polyps are under development, so Cologuards day in the sun will likely be limited
(a critically important factor given that EXASs valuation is entirely dependent on
Cologuards anticipated success many years into the future)
A recently published article (www.ncbi.nlm.nih.gov/pubmed/23704278) highlights early
development of a microRNA biomarker diagnostic test using a simple blood draw that has
an 81% sensitivity in pre-cancerous colon cancer detection (vs. 41% for Cologuard) and
92% sensitivity in detection of colorectal cancer (same as Cologuard)
This test uses a single miRNA marker; the research group is looking at a number of other
microDNA markers to further enhance the sensitivity and it is highly probable that other
markers will also be found to be effective
This research is garnering significant attention within the scientific community, but is
currently unknown by the financial community
All of these alternatives undermine the long-term potential of Cologuard
and underscore the exaggerated valuation of EXAS
Exact Sciences Has Asked for a Very High
Reimbursement Rate for Cologuard
This is what Exact Sciences is asking for (proposed Cologuard
reimbursement crosswalk):
Source: Exact Sciences annual meeting presentation, 7/22/14.
There May Be a Negative Surprise When CMS
Establishes Its Reimbursement Rate for Cologuard
(Expected Any Day Now)
A report by Gravity Research questions whether the Centers for Medicare and
Medicaid Services (CMS) will establish a reimbursement rate anywhere close to
what the company and its investors expect:
Based on extensive diligence and consultations with industry experts (including a former
senior CMS employee), we are confident that CMS and its Medicare Administrative
Contractors (MACs) will establish a reimbursement rate for Cologuard that is at least 70-
80% lower than the ~$500 rate EXAS has projected to investors due to CMS using a gap-
fill process to price the test rather than the crosswalk analysis EXAS has repeatedly
claimed will be used. We also think there is a meaningful probability that CMS may simply
decide to issue a negative National Coverage Determination and refuse to cover
Cologuard, as CMS did in 2009 with the CT colonography (CTC) when it became clear
that while CT colonographies were capable of diagnosing cancer and allowing physicians
to detect polyps, they were far from being cost-effective at the reimbursement prices
required to make the test economical for practitioners.
The DNA tests contained within Cologuard, which account for over 95% of the value in
EXAS hypothetical crosswalk analysis, were explicitly banned by the Department of
Health and Human Services (HHS, parent bureau of CMS) in 2012 from being
reimbursed as diagnostic tests (as they would be used in Cologuard).
It is clear from published CMS datathat even a $150/test reimbursement rate for
Cologuard is a major stretch. We also find it very telling that EXAS has been unable to
find any partners for Cologuard and has not published its own cost-effectiveness study for
Cologuard despite purportedly working on one since 2011.
Source: Gravity Research report, 4/30/14.
Commercial Payor Adoption May Be Slower
Than Anticipated
Aetna recently announced that it does not cover Cologuard and views the
test as experimental and investigational
Comparative-effectiveness studies are now needed to clarify the role of stool
DNA testing with respect to programmatic screening with other test options.
Only through a better understanding of other key factors, such as the screening
interval, adherence, cost, and diagnostic evaluation of positive results, can we
determine the appropriate place for stool DNA testing on the screening menu.
Maxim Group report (8/22/14):
Commercial payors are likely to use a more market-based approach to
reimbursement. The government recently made steps toward adopting a more
market-based approach to reimbursement. While those changes do not take
effect until 2017, we anticipate that commercial payors will selectively be more
proactive in reimbursing new tests at what they view as market rates and not
based on the methodologies currently used by CMS. The Cologuard is in
competition with $20-$30 FIT tests, as well as emerging blood-based tests,
which creates a challenging market environment, in our view.
More than 60% of CRC patients are over 65 years old so commercial
payors have historically avoided reimbursement of screening tests because
a payor's members today may not be their members when the benefits are
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 TTM
H1 '14
Total Revenue
Net Income
Exact Sciences Has Never Generated Meaningful
Revenues and Its Losses Are Accelerating
Source: CapitalIQ.
In Q2 14, revenues were zero and net loss was $19.4 million
Q3 10 Q4 10 Q1 11 Q2 11 Q3 11 Q4 11 Q1 12 Q2 12 Q3 12 Q4 12 Q1 13 Q2 13 Q3 13 Q4 13 Q1 14 Q2 14
Exact Sciences Quarterly Cash Burn Is Rising
And Will Intensify as the Sales Force Is Hired
FCF is operating cash flow minus cap ex
Source: CapitalIQ.
Free Cash Flow
Cash burn could approach $100 million in 2015
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Q2 14
The share count has more than tripled in the past six years
To Fund Its Losses, Exact Sciences Has Issued More
and More Shares, Diluting Shareholders
Source: CapitalIQ.
Diluted Shares Outstanding
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 TTM
Q2 14
Total Revenue
Earnings from Cont.
Sequenom, Another Molecular Diagnostics Company,
Has Meaningful Revenues and Smaller Losses
Recently Yet Only a $425 Million Market Cap
Source: CapitalIQ.
Net Income

Exact Sciences Stock Is Wildly Overvalued
Stock price (8/8/14 close): $22.14
Market cap: $1.82 billion
Cash: $235 million
Debt: $1 million
Enterprise value: $1.58 billion
TTM EPS: -$0.80
2014 est. EPS: -$1.14
2015 est. EPS: -$1.06
2015 est. revenue: $47-$100 million
2017 est. revenue: $270-$366 million
Even if the company achieves $366 million in revenues in 2017 (which is
extremely unlikely), analysts are valuing EXAS today at five times this
amount! (I am not making this up)
How I Think It Will Play Out
Weve seen this story before: Cologuard is Exact Sciences third attempt
at a stool DNA-based diagnostic and the first two (PreGen Plus and
ColoSure) were total busts, never obtaining over $250,000/quarter in
sales (the best quarterly sales, in Q4 2004, were a mere ~700 diagnostic
The earlier tests were laboratory-developed tests and thus didn't go through
the Premarket Approval/FDA approval process that Cologuard did, but the
earlier tests were known and simply not used
One analyst (Jeffries) is projecting 215,000 tests in 2015, 500,000 tests in
2016 and 800,000 tests in 2017
Id be shocked if the company achieves even 10% of this amount
By early 2015, it should be clear that Cologuard is a commercial flop and
the stock will collapse
I Think This Will Meet the Same Fate as the
Amazon Fire Phone
A hugely hyped product entering a crowded market with high
expectations and is a total bust
This was the lead story in the business section of todays NY Times:
My (Generous) Price Target Is $8
In its report assigning EXAS a Sell rating, Maxim Group writes:
Valuation is expensive. Shares of EXAS trade at EV/revenue multiples of
6.8x and 5.3x our 2017 and 2018 revenue outlooks, respectively, compared to
peer 2014 and 2015 averages of 46x and 4.1x. Our 12-month target price of
$8 is based on EXAS trading at a EV/revenue multiple of 3.5x our 2018
revenue outlook and discounted back to 2015. We believe that, in 2018, the
company should trade at a discount to the peer average, given our view that
blood-based screening tests are a significant competitive threat.
I think this is generous: my best guess is that, as Cologuard fails in the
marketplace, the stock falls 50% in the next six months (could happen
any day if CMS reimbursement levels disappoint), 80% in the next
year, and 90% in the next two years
Summary: There Are Many Ways to Win
The valuation is extreme a nearly $2 billion market cap for a single
diagnostic product company
Patients reject Cologuards poop-in-a-cup system
Physicians resist switching away from a FIT test they know and trust
Reimbursement levels are lower than the company and investors expect
Competition emerges