Most of the stories you will read today about the 2,200-page document that lays out how Lehman Brothers used accounting gimmicks to conceal its true financial condition will understate just how important the lies told by its top executives were.

This is one of those few news stories where there is much more than meets eye. The headlines are understating the seriousness of the deception Lehman’s executives employed in an effort to fool investors and creditors about the health of their investment bank.

The health of Lehman’s balance sheet was such an important question in 2008 that the bank went out of its way to claim multiple times that it was reducing the size of its balance sheet. Let’s start with the earnings call in June 2008.

“Regarding our balance sheet, we reduced our gross assets by $147 billion over the quarter, which exceeded the targets that we set,” chief executive Dick Fuld said at the start of the June 16th conference call in 2008.

“Turning now to leverage, we reduced our gross assets by $147 billion — from $786 billion to $639 billion — in the second quarter and we reduced net assets by $70 billion — from $397 billion to $327 billion. As a result, we reduced our gross leverage from 31.7X times to 24.3X at May 31, and we reduced net leverage from 15.4X to 12X prior to the impact of last week’s capital raise,” chief financial officer Ian Lowitt said on the same call.

Thanks to the bankruptcy examiner’s report, we now know this was not true. Lehman’s deleveraging was largely an accounting fiction. Fifty billion of it’s supposedly $70 billion reduction in assets was produced entirely through the Repo 105 transactions.

The importance of this deception cannot be overstated. Their should be no doubt in anyone’s mind that the amount of leverage and the size of the balance sheet was pretty much all that mattered at the time. The catch phrase at the time was “Earnings are the past. The balance sheet is the future.” The extra details the firm was offering on that June conference call were meant to reassure everyone about the health of the balance sheet.

On that same call, the third question came from Merrill’s Guy Moszkowski.

Guy Moszkowski, Merrill Lynch

Just a follow-up on the question about the asset sales and whether there were vintage concentrations or anything like that. How about with respect to timing? Were the sales pretty much ratably spread over the quarter, or were they more skewed toward either the earlier or the latter part of the quarter?

Ian T. Lowitt, Chief Financial Officer

They were spread over the whole quarter. I mean, it was a focus of the entire firm to de-lever through the course of the quarter. That was obviously a focus which shifted attention, to some extent, and I think that impacted the quarter in some ways. But it was even across the whole quarter so there was no concentration in terms of the timing. That was true across all of the elements, so that would be true within residential as within commercial.

This wasn’t true at all. In fact, according to the bankruptcy examiner’s report, $50 billion in alleged “sales” were actually repos timed to reduce the balance sheet for exactly the period necessary for earnings reporting.

(AMEX:QCC)

Hedge fund investing is generally restricted to investors meeting minimum asset levels (i.e. rich people, the thinking being that they’ll be all right if they lose a bunch of money) or those making large minimum investments (the thinking being that investors who plunk down $150K on an investment will do their due diligence, unlike the typical retail investor). But for all intents and purposes, it appears that Quest Capital (QCC) is trying to convert itself into a quasi hedge fund.

Long-time readers of this site will already know that Quest Capital has been a stock favorite of ours for a while now. In a move to increase its returns and stock price, Quest appears to be changing business lines, and is taking on a lot of characteristics that one normally associates with hedge funds. Hedge funds are known for their high, but incentive-laden compensation structures and high management ownership levels, with the idea of aligning shareholder interests with those of managers. Quest is emulating this strategy with its proposed move.

Rather than pay salaries and offer bonus/option plans to managers, Quest will pay a management company 2% of its asset value (annually), and 20% of the excess returns it generates. Furthermore, this company will make a $25 million investment in the firm, thus better aligning its interests with those of shareholders. Unfortunately for existing shareholders, this investment will happen at a price that is below the company’s current book value, thus diluting the shares of existing investors.

Layne is divided into three operating segments: water and waste water (76% of 2009 revenues), mineral exploration (19%), and energy (5%). Its clients include municipalities, water utilities, global mining companies, oil and gas companies, and consulting civil engineers.

The largest segment of LAYN’s business deals with water. The company provides water well drilling services, water and sewer distribution remediation services, and waste water treatment services. As water management becomes more critical, LAYN’s services to repair in-the-ground distribution pipes for both water and sewer become more important.

Water shortages increase demand for LAYN’s well drilling services. Deep well disposal of power plant wastewater is a growing, and profitable, niche business in Florida. Of particular interest are its treatment facilities for the water used in natural gas shale fracing processes. As unconventional drilling increases, the need to treat drilling wastewater should provide parallel opportunities for LAYN.

Its mineral exploration business provides services to the mining industry, focusing on the copper and gold markets. In addition, this section provides soil improvement services for civil engineering construction project, such as levies and pipelines.

Layne owns and operates 45 natural gas wells, which are mainly located in the Midwest. Production is relatively small, and the company is not looking to become a big player in this field. LAYNE’s production is around 18.8 thousand cf/d. The company does not currently have the expertise to drill horizontal shale gas wells, but should gain parallel business from its shale well water waste solutions.

However, offsetting these outstanding niche markets, a large portion of LAYN business depends on the capital expenditures and repair budgets of local governments and utilities. With the current sad state of municipal financial affairs, many infrastructure upgrades are being delayed. In addition, residential water drilling is dependent on a healthy new construction market.

LAYN uses a fiscal January 31st year-end schedule for financial reporting. Layne reported 1st quarter 2010 ending April 30, and beat expectations (see conference call transcript here). The consensus on the street was $0.22/share, and the company reported a solid performance of $0.34/share. Revenues for the quarter increased 13% to $230.7 million.

The increase was driven by a rebound in the mining exploration business (+85% YOY) and higher overall gross margins (25.5% versus 21.7% YOY). Water related revenues were relatively flat at 2.9% growth, and the energy sector experienced a decline. Municipal and residential water business remains weak, but it is offset by strength in the commercial/industrial/military sectors. Due to low current market conditions, LAYN has not renewed its expired natural gas hedges that were sold at $7.17. With spot market prices in the $4.00 range, and futures in the $6.00 range, management is going to wait for better market conditions before setting additional hedges.

Layne Christensen offers interesting growth prospects due to its diverse and niche businesses – providing potable water to the military in Afghanistan, drilling waste disposal wells for power plants, treating waste from shale drilling, and repairing damaged municipal water/sewer pipes in-place without the need to dig them up.

Layne is a small cap company with a market cap of $517 million, has 19.5 million shares outstanding, and carries a very small debt of $26 million. Cash on hand as of 4/30 is $67 million, or $3.45 per share.

EPS in 2010 should be in the $0.90 to $1.20 range on revenues of $930 million. Next year, management is anticipated to generate around $1.45 to $1.60/share in earnings on revenues of $980 million. This is based on slightly better performance in the water business, continuing strength in the mining sector, and flat performance from the energy sector.

Historically, Lane Christensen’s stock price valuations have been on the expensive side. The followers on the street seem to like the fundamentals of the company, but several believe the current price already reflects an earnings turnaround, and therefore rate LAYN as a hold based on valuation. These are some concerns that the strength of the mining business may not continue through year end, along with anticipated weak water and natural gas markets.

Layne Christensen deserves to be on a list of cyclical stocks to research. The company is well positioned in niche markets that will experience a rebound as economic activity picks up here and abroad. LAYN has the ability to generate $2.20/share in earnings within a few years. This will match its previous record earnings in 2007 and 2008.

The stock appreciated 12% upon release of 1st quarter numbers, and is in the middle of its trading range of $24 to $30 since November 2009. LAYN should reach the low- to mid-$30s during middle-cycle valuations, and upwards of $40+ at the peak of the next business cycle, as all sectors recover from the recession. While a bit expensive at its current price, I think LAYN is worth buying on pullbacks to the $24-$25 area, and a dip below this level could be a good value.

Disclosure: Author long LAYN

According to a Company press release, CBRX was approached by another “global pharmaceutical company” to acquire the “assets and shares” of CBRX subject to the deal with Watson. Watson obviously countered with the “forgivable” loan. I basically see this as a combination of a sweetened deal with CBRX (i.e. here is $15 million, please deal only with us) and a small poison pill to add a little extra pain to a potential buyer of the Company ($2 million extra). The fact that Watson is willing to pony up an additional $15 million (thus enhancing the total cash deal value by 16%) demonstrates quite directly the confidence in the product potential. The fact that an outside global pharmaceutical is attempting to get involved further supports this confidence.

A few weeks back I wrote about CBRX being an interesting trade: today’s announcement, in conjunction with the share price still trading close to $1, makes it even more interesting. Obviously the risks are high, but this deal just got better.

Read the previous article here.

Disclosure: Author long CBRX

ATPG approaches the oil industry much like Apache (APA) did back in the late 1990s, purchasing cast-off reserve assets from other oil companies, cutting overhead, and further developing the asset. 87% of ATPG’s oil and gas reserves are classified as “proven and undeveloped.” Within these large undeveloped fields lies the opportunity to increase stated reserves as they become developed. When purchased, these fields were assigned a reserve total based on the previous owner’s development history. However, by drilling deeper and using newer techniques, ATPG has the opportunity to increase the amount of oil and gas recovered.

Management’s success ratio in converting undeveloped reserves into developed reserves is 98%, making ATPG more of a development company than most of its E&P peers. For example, ATPG is currently deploying a new large development platform in the Gulf of Mexico named the Titian in order to rework a previously producing field. ATPG has spent $1.2 billion on the Titan and a new production hub called the Telemark Hub. In September ’09, ATPG announced that the Hub’s Mississippi Canyon 941 well #3 encountered 266 feet of net pay, or triple the amount found in the original results from the previous owner. This was accomplished by drilling deeper into the reserves.

ATPG takes on big projects, needing large investments in infrastructure and capital expenditures. Unlike some, APTG has historically used debt to finance asset acquisitions, infrastructure, and capital expenditures. In “normal” credit times, banks were accommodative to ATPG’s business plan, albeit with expensive and restrictive credit terms. However, when credit became difficult to obtain in early ’09, along with temporary low oil prices that reduced cash flow, ATPG’s business plan became a victim of the times. Assets were monetized, bank fees were paid to loosen loan covenants and, for some, ATPG’s survival was in doubt.

Management spent 2009 and early this year righting the ship – they raised capital through a series of common and preferred share offerings, obtained vendor-provided cap ex financing in the form of NPI (working interests) tied to production, and replaced bank debt with private capital debt. The reward of their efforts is the deployment of the Titan drilling and production platform along with the development of the Telemark Hub.

This asset is the most technologically advanced platform in the world, with a useful life of over 40 years. The Titan/Telemark capital expenditure investment has been $1.2 billion so far, with $300 million allocated for this year. The Telemark Hub is critical to ATPG’s projected production increase from an average 16 mboe/d (35 mmcfe) in ’09 to an exit rate of about 50 mboe/d (58-61 mmcfe) this year, and, by some estimates, over 80 mboe/d (99-117 mmcfe) in 2011.

So far this year, management has been focused on re-working previous wells and tying them into the Titan infrastructure. Production targets are for new wells brought to commercial production in each quarter. Progress was moving ahead and the Street was beginning to notice, exemplified by its stock price rising to the low $20s.

Oil companies are best valued in terms of operating cash flow rather than earnings. ATPG’s substantial production increase is estimated to generate operating cash flow per share of $4.30-$6.60 in 2010 and $13-$16 in 2011.

However, then came the BP (BP) oil spill – and the political and operational uncertainties now associated with the future of Gulf of Mexico exploration along with it. As investors hate uncertainty, the stock has sold off hard, down 45%.

There will be changes in the Gulf of Mexico exploration business going forward that will increase the costs to do business. There will be delays on projects slated for this year. However, for those who believe there will continue to be increasing oil production out of the Gulf of Mexico, ATPG could provide interesting opportunities at its current stock price, but with risk.

As of today, there is confusion on which specific wells and issued permits will be affected by a moratorium, along with the timing/process/requirements for future approval of permits. ATPG utilizes some re-entry of existing wells that may be subject to fewer restrictions.

The production profile outlined in ATPG’s latest investor presentation lays out the medium-term opportunity for growth. Cash flow estimates are based on this profile. The issue for APTG going forward is not its production profile, but the timing of achieving these rates.

ATPG has the ability to generate more cash flow than its current share price. Today’s new investors will be well rewarded by accepting the risk of the timing of higher production. ATPG is a higher risk / higher reward opportunity with current share prices selling at a 55% to 65% discount to its NAV of $27 – $35, and as low as 0.75 x cash flow at production rates of 80 mboe.

It is important to adequately conduct due diligence with ATPG. Management carries plenty of leverage that is more than offset by substantial project-oriented assets. There is a large short position on ATPG, some as a hedge associated with the recently issued preferred offering and some betting against the company. The ability to monetize its assets provided a safety net for management and investors during very, very tough times, and may be needed again. A good place to start a review is their upcoming annual shareholders meeting and the latest presentation.

Disclosure: Author long ATPG

Citigroup Inc. (NYSE: C) stock reached a high of $3.93 in trading. It closed 1.82% higher at $3.92, with volume at 551.97 million. Citigroup stock has a 52-week range of $2.55-$5.43. It is currently trading below its 50-day and 200-day moving averages. The stock has seen support at $3.81 and resistance at around $4.

Shares of Alcoa Inc. (NYSE: AA) jumped more than 2% in today’s trading. The stock reached a high of $11.49 in trading. It closed 2.59% higher at $11.48, with volume at 26.12 million. The stock was active again in after-hours trading, rising 0.09% to $11.49. Alcoa shares have a 52-week range of $8.96-$17.60 and are currently trading below its 50-day and 200-day moving averages. The stock has seen support at around $11.02 and resistance at around $11.85.

A few weeks ago the company secured a game-changing licensing, settlement and supply agreement with Alcon (NYSE:ACL), a $7.5 billion company considered the Microsoft (NASDAQ:MSFT) of the ophthalmology sector. The licensing and settlement deal with Alcon puts the company on the map and validates their IP and next-generation technology. In addition, the deal dramatically improves the company’s balance sheet, from one beholden to $11 million in net-debt to a company now with $5-6 million in net cash on its balance sheet. The dramatically improved balance sheet is a big deal for SURG when you consider its market cap is only $70 million.

The good news does not stop there. For those who like to spend their free time digging through remote S.E.C. filings late at night (like we do!), you would have discovered what we feel is the most revealing aspect to this deal: Alcon is going to make Synergetics a third-party manufacturer for those products that are being cross-licensed to Alcon. As part of this arrangement, Alcon has agreed to give Synergetics $2 million to upgrade its manufacturing capability to support the expected ramp of these products.

Let’s apply some logic here. If the supply component of the Alcon deal was not going to be a significant generator of future revenues for SURG, why would Alcon pay the company $2 million to ramp up its manufacturing capacity? In our view, the Alcon deal could ultimately become a transformative source of revenue growth for SURG, growth that should immediately flow to the bottom-line. On its brief conference call announcing the Alcon deal, SURG’s CEO, Dave Hable, stated as much, saying:

The supply agreement with Alcon would have a material impact on its existing manufacturing base.

With recent cost cuts already in place and improved efficiencies with its lean manuacturing process achieved, SURG may soon be generating $1-$2 million in cash per quarter. Now, when you consider this side of the story and add in the potential for $.08-$.10 in quarterly earnings starting in a quarter or two, SURG could have considerable upside from current prices in a good market.

Turning to the technical side of the ledger, the stock’s strength is truly eye-catching. Upon “surging higher” after the deal with Alcon was announced, SURG has held onto all of its most recent gains. As far as we can see, it is one of the only stocks to have exhibited such relative strength through the “Flash Crash” and the recent test of the lows. Any move through $3 should usher in a new up-leg for the stock.

Earnings are due in a few weeks, and we expect a very upbeat conference call, further details on the Alcon deal, and a positive update on the company’s other side of its business, the neurology side. Considering the undiscovered nature of the stock, its relative strength and a near-term catalyst to propel shares, we remain buyers of SURG at current prices and on pullbacks to $2.7-$2.8.

Disclosure: Author long SURG

About the author: The Inflection Point

The Inflection Point (TIP™) is a weekly long/short market newsletter focused on market trends and companies at important inflection points in both their business models and technical stock formations. TIP™ is produced each week by John Henderson, an independent trader, and his team of market… More

This article discusses iShares Russell 2000 Index (NYSE:IWM). Our regular readers have undoubtedly noticed that we have a tendency to discuss small cap stocks quite a bit on this site. Why? Because among the small cap universe some of the most inefficiently priced stocks can be found. They carry little in the way of name recognition for retail investors, and they don’t move the dial enough for institutional investors (their budget calculators show that the returns just aren’t worth it).

With the aim of cutting its cash burn by $4m-$5m last summer, Anadys went through a restructuring that involved trimming its workforce by 40% and suspending work on a second hep C candidate, ANA773. But it remains a company with just $15.5m in cash at the end of March and a burn rate of $4m-$5m per quarter, meaning phase III will not happen without a partner or new investment.

Higher dose

The latest data on the hepatitis C polymerase inhibitor, released Friday, indicates that a twice-daily 400mg dose plus the standard combination therapy of pegylated interferon and ribavarin achieved undetectable levels of virus in 75% of patients after 12 weeks of treatment, compared with 63% of patients taking a placebo and standard combination therapy.

That follows on the company’s announcement in February that 73% of patients on a twice-daily 200mg regimen achieved the undetectable levels of virus, known as a complete early virological response (cEVR). In Friday’s announcement, the company said of the 18 patients on the 200mg regimen achieving cEVR, 17 have maintained it after an additional 12 weeks of study in which they were receiving the standard combination therapy.

The main concern with the drug remains the development of a skin rash, which was the safety signal that caused its shares to plummet last April when the company announced phase I data. In the phase II trial, incidence of rash was comparable in the 200mg group and placebo arm, 12/29 vs. 10/32, but in the 400mg group 20/34 developed a rash.

This lower incidence of rash, comparable efficacy and the fact the 200mg dose appears to be showing sustained benefits could mean that the group may well decide to go with this dosage level if it progresses to phase III trials.

Anadys shares rose 3% to $2.40 on Friday, giving the company a market capitalization of $90m.

Crowded field

With an estimated launch date of 2013, ANA598 will be entering a crowded field in the hepatitis C space (Therapeutic focus – Hepatitis C waits for better treatments, February 16, 2010). No fewer than five phase III candidates will be entering the market in 2011 and 2012, with Johnson & Johnson (JNJ) and Vertex Pharmaceuticals’ (VRTX) VX-950, a protease inhibitor, expected to ring up blockbuster sales and dominate the market.

In addition, J&J has another protease inhibitor in phase II, TMC435, due to launch in 2011, with 2016 estimates pencilled in at $329m. As such, it is unsurprising that forecasts for ANA598 are relatively low; according to consensus forecasts from EvaluatePharma, ANA598 is estimated to achieve $79m in sales in 2016.

In the face of such competition on an analyst conference call on Friday, company executives were keen to talk up the results and said the data establish ANA598 as the most attractive non-nucleoside in hepatitis C treatment. There was, however, little detail on any progess the group was making on crucial partnering talks, but the 12-week safety data should help to reignite any interest that is out there.

However, with a cash runway that may end abruptly in 2010, Anadys cannot afford to hang about in getting a partner or more money to move the product into phase III. The phase II program is scheduled to finish in October, and the data needs to continue to be robust or the likelihood of attracting a partner or new investors will start to look very slim indeed.

About the author: EP Vantage

EP Vantage is a new forward-looking comment and analysis service tailored to the needs of pharma and finance professionals, focusing on the events that will define the future of companies, products and therapy areas. Written by experienced journalists, EP Vantage provides timely financial… More

• Company: EP Vantage