Description

Woodford Patient Capital Trust, (“WPCT”) or the (“Company”) is a closed-ended public investment vehicle launched in April of 2015 by Woodford Investment Management.  As of February 2019, the Company had total gross assets of £1.02 billion and a market capitalization of £712 million.  Adjusting for net debt the shares now trade at a ~17% discount to NAV. 

A discount on a sleepy investment trust may strike investors as a buying opportunity. Yet rather than a “patient” manager of shareholder capital, we view WPCT as a collection of overvalued and in some cases highly questionable businesses, veiled by its direction by one of the UK’s most venerated fund managers - Neil Woodford.  We believe Neil Woodford uses the capital entrusted to WPCT to bail out his flagship fund, the Woodford Equity Income Fund (“WEIF”).  Rather than investing in high quality stocks, WPCT buys start-ups of questionable value from WEIF at absurd valuations all in a futile attempt to artificially bolster performance at WEIF.

WPCT’s portfolio consists primarily of UK companies. As part of the portion of its portfolio held in unquoted stocks WPCT invests in early-stage companies, describing this strategy as “buying stakes in businesses with outstanding intellectual property and helping them fulfil their growth potential through the deployment of long-term patient capital”. The rest of the portfolio is comprised of positions in quoted/listed companies with larger market capitalisations.

Investment Thesis:

1)      WPCT bailing out WEIF to distort WEIF’s performance and avert its collapse.

After an illustrious career at Invesco, Woodford established his own fund in 2014 - Woodford Equity Income Fund (“WEIF”).  This flagship fund had AUM of £15 billion in 2014.  However, poor performance has triggered redemptions and the fund has shrunk to £4.8 billion as of January 2019.

WEIF is an open-ended fund with daily redemption rights. The Financial Conduct Authority (FCA) imposes a 10% limit on the proportion of unquoted holdings held by such funds. As of the beginning of March however, WEIF had as much as ~18% of its assets tied up in unquoted holdings particularly after a significant fall in the share prices of a number of its listed holdings such as Provident Financial, Prothena and Allied Minds. Given the difficulty of selling unquoted positions in startups combined with the illiquid nature of most of the AIM-listed stocks that WEIF holds, the fund has had trouble keeping within the 10% threshold of unquoted holdings set by the FCA.

• WPCT/WEIF swap transactions

WEIF has resorted to the transfer of portions of its unquoted positions to WPCT in return for WPCT shares. The latest such transaction involved the transfer of stakes in Atom Bank, RateSetter, Cell Medica, Spin Memory and Carrick Therapeutics worth £73M and £6M in cash to WPCT in return for a stake in the latter of 9%.

While performance at WEIF was already dire, it would have been far worse based purely on quoted holdings.  Performance at WEIF is held up by the marking up of biotech startups with multi-billion-dollar valuations where Woodford funds and related parties are often the only material investors. Without the high mark ups of these UK startups, WEIF would have reported dire performance and redemptions would have been even higher. 

The marked up valuations of these unquoted businesses that WEIF has relied on for its performance, however, also implies that the valuations at which the swap transactions have taken place have most probably been very high, resulting in WPCT having no choice but to pay large amounts for WEIF’s unquoted positions, for no other reason but to ensure the latter’s compliance with regulatory requirements.

WPCT, on the other hand, is left holding a gradually increasing share of these unquoted stocks, which are (as expanded on below) often of questionable quality and value. Moreover, the aforementioned transaction which took place in Q1 2019, is only the first stage in a process where most of WEIF’s unquoted positions will be transferred to WPCT, as WEIF starts to focus solely on publicly listed shares rather than private companies.

• Listing of WEIF’s stakes in unquoted companies

Along with swap transactions where stakes in unquoted companies are transferred to WPCT in return for WPCT shares for the purposes of remaining within the FCA set threshold for unquoted holdings, Woodford has been resorting to the listing of some of these unquoted companies.

While not being a key part of our short thesis, we believe these listings are worth considering given their suspect nature and what they imply about the quality of the listed assets. While initially expected to float stakes in some of these unquoted companies on main exchanges such as the London Stock Exchange, Woodford ended up listing them (e.g. Industrial Heat, Benevolent AI) on the much smaller International Stock Exchange in Guernsey. In addition, the issuing of preference shares has allowed Woodford to list solely WEIF’s stakes in these companies, obviating the need to list at least 25% of a company and avoiding having to involve other investors in the process.

Overall, the choice of exchange for the listings as well as their structuring is a red flag most likely implying that these companies were unsuitable for listings on the main markets where much more stringent regulatory requirements would have revealed more than Woodford would like to reveal about its unquoted holdings.

2)      Reliance on the mark up of unquoted biotech stocks for returns.   

WPCT performance is entirely reliant on the mark up of unquoted positions (as in the case of WEIF described above). Note the dire performance of the portfolio where Woodford cannot control the valuation of the stocks (i.e. in the case of quoted positions):

 Source: Company Filings

WPCT’s largest holdings are now dominated by unquoted biotech stocks. Contrasting WPCT’s holdings as of January 2016 with the latest fact sheet of February 2019, one can see the increase in the proportion of the trust held in unquoted stocks.  Note that the quoted stocks named in the 2016 top 10 holdings have been declining in recent months, with Prothena for example having fallen 70% to date, evidencing WPCT’s reliance on the mark up of unquoted stocks for bolstering returns. 

 Source: February 2019 Fact Sheet

Source: January 2016 Fact Sheet

3) Industrial Heat: the £2.6Bn cold fusion start up – 2^nd biggest holding seems to be of questionable value

WPCT’s 2^nd biggest position is Industrial Heat LLC.  This holding is the largest and most egregious manipulation of asset value in a portfolio of speculative overvalued assets.

 Industrial Heat constituted 1.88% of WPCT’s $796 million investment portfolio in 2015.  Implying a value of £15 million for the position.  No underlying share ownership is disclosed.

Source: WPCT Annual Report 2015

WPCT refer to Industrial Heat in their 2016 annual report.  The underlying holding is also disclosed.  As of this point in time, 14.2% of Industrial Heat and 45% of Industrial Heat A2 are held by WPCT. 

Source: WPCT Annual Report 2016

We use disclosures above to derive the 2016 implied asset values.  Assuming no change in ownership during the year, Industrial Heat appears to have been marked up from a value of £15 million to £17.6 million over the duration of 2016, implying a total value for Industrial Heat amounting to £101 million.

Source: WPCT Annual Report 2016, own calculation

By contrast, the WPCT website states that the value of shares in Industrial Heat were marked down in 2016.

Source: WPCT Website

In 2017, Industrial Heat’s value once again appears to have been marked up.  Industrial Heat is also disclosed as a holding in WEIF. 

Source: WEIF Annual Report 2017

Note that WPCT’s holding in Industrial Heat at this point was just 1.4% and 11.6% across A1 and A2 shares.   

Source: WPCT Annual Report 2017

From this information, we can calculate the 2017 total equity value for Industrial Heat.  We note that the value of Industrial Heat had increased 7x from the £101 million valuation the year before.

Source: WPCT Annual Report 2017, own calculation

The share of Industrial Heat held by WPCT as of 2017 had fallen from 45% to just 1.4% in A1 shares and 11.6% in A2 shares.  But the value of holdings in Industrial Heat held by WPCT had only decreased from £17.6 million to £11 million.   

Without forensically following the multiple percentage changes across the fifty or so names in the WPCT portfolio, it would be easy to think that Industrial Heat was marked down 37.5% (11/17.6-1).  As we have shown, there was actually a valuation mark up of 7x. (706.8m/101.1m)

In the interim half year accounts for June 2018 - the latest available for WEIF, Industrial Heat is marked up an additional 66%.  Note that the underlying shareholdings have not changed in WEIF filings since 2017 but the holding values have increased.

Source: WPCT Annual Report 2017, own calculation

By 2018, WEIF held 2.44% of the entire fund in Industrial Heat stock.  This sum of these holdings is valued by Woodford at £113 million.

Source: WPCT Annual Report 2017, own calculation

WPCT has at least 8.92% of its funds in Industrial Heat as of February 2019.

Source: WPCT Website

Taking the ownership as it was last disclosed in 2017, we calculate a marked-up value of £2.6+ billon for Industrial Heat:

Source: WPCT Annual Report 2017, WEIF Interim 2018 Report, own calculation

Woodford reported a mark-up of Industrial Heat of 357% in October 2018.

Source: WPCT Website

Bearish financial news website - Share Prophets, calculated that this implied a total value for Industrial Heat of $112.9 million post mark up. 

Source: Share prophets

However, we calculate that Woodford has actually marked Industrial Heat up to an enterprise value north of £2.6 billion. We believe this aggressive mark up of Industrial Heat to $2.6 billion is unwarranted. 

An analysis of Industrial Heat’s underlying business makes us question the value of this investment.

•  Industrial Heat.  A lot of hot air?

 Woodford teamed up with Cherokee Investment Partners (Cherokee) to invest in Industrial Heat in May 2015.    

Source: WPCT Website

Local news reports claim that Industrial Heat was “run” by Tom Darden - CEO of Cherokee, in 2012. 

• Cherokee: A sophisticated $2 billion fund?

 Cherokee claims to be a $2 billion private equity house, although the website seems to be a quick “BlogSpot” creation. Cherokee is based in North Carolina on a retail street.

 Source: Maps

Cherokee does not have a Bloomberg terminal and seems to have regulatory assets which are a fraction of its reported $2 billion AUM.

Source: SEC filing

The SEC brought actions against Cherokee for overcharging clients in 2015.  This claim was settled by Cherokee.

Source: News site

Additionally, SEC charged Cherokee for repeat filing failures.  The SEC found that Cherokee were delinquent in their filings over a multi-year period.

Source: SEC

We note that Cherokee founder - Tom Darden, worked at a brick manufacturer for most of his career rising to the position of Chairman.

Source: Linkedin

To summarise, Cherokee appears to be a relatively small real estate fund run by a former Chairman of a brick manufacturing company.  Cherokee has been convicted by the SEC of misdealings and appears to have limited presence and resources.

•  Andrea Rossi:  The Man Behind Cold Fusion

A 68-year-old Italian living in Miami - Andrea Rossi, has long claimed to have created a device, known as the E-Cat which can generate energy using cold fusion - a technique which mainstream science deems impossible (https://ftalphaville.ft.com/2016/11/25/2180322/so-neil-woodford-invested-in-a-cold-fusion-company/).

Rossi swears by his claims that the E-Cat works although independent tests have been unable to verify this. In addition, Rossi is a convicted fraudster with a chequered history.  Since the 1970s, Rossi has been claiming to have made various technologies which “convert organic waste into petroleum” but these designs haven’t borne fruit. They did, however, result in Rossi being arrested on allegations of fraud.

•  Looking deeper into Industrial Heat

Industrial Heat was established by Cherokee Investment Partners in 2012.  Court documents name Darden and Vaughn - both partners at Cherokee, as the President and Vice President of Industrial Heat.  Note the “principal place of business” address for Industrial Heat is the same as that for Cherokee. What’s more, we could not find any website or employees for Industrial Heat other than Darden and Vaughn.

Source: Court Document

Industrial Heat, i.e. Darden at Cherokee, teamed up with Rossi and bought the right to license the E-Cat in the USA in 2012. In May 2015, according to legal news site - Lawyer360, Woodford invested $50 million for a 4% interest in Industrial Heat. 

This implies that Darden’s Industrial Heat, with its investment in Rossi’s cold fusion technology was worth $1.25 billion.

Rossi and Cherokee fell out after Woodford’s investment and Cherokee went on to claim that the E-Cat was actually a "sham".

Industrial Heat was undergoing a protracted legal battle which Rossi filed in April of 2016, where he alleged that the defendants – Darden and Cherokee, engaged in a “fraudulent scheme” to use his IP without paying the amount agreed to at the outset. What is particularly revealing is the counterclaim by the defendants, where Industrial Heat’s own founders claim that the technology was a sham and that the energy producing capabilities of the technology “are not scientifically verifiable or reproducible”. Over this same period, while the lawsuit was still going on, WPCT and WEIF filings imply that the value of Industrial Heat increased to £2.6 billion.

Conclusion: Woodford has invested in a highly suspicious entity with no discernible footprint.  Despite no verifiable third-party evidence to suggest the existence of Industrial Heat as a business, Woodford has increased the valuation for the business to £2.6 billion.  We believe Industrial Heat is worth zero. 

4) Top 10 holdings highly suspicious.

It is important to note that the coming to light of Industrial Heat’s actual value is in itself sufficient to drive WPCT’s share price substantially lower given that the company forms ~9% of WPCT’s NAV. But while Industrial Heat is the most egregious of WPCT’s top holdings, the rest don’t inspire particular confidence either.

•  Oxford Nanopore

While certainly not as speculative a company as Industrial Heat (the whole purpose of which revolves around a pseudo-science), Nanopore’s implied valuation from its latest funding round is still highly doubtful given the myriad of issues that the company and its technology are facing.

First of all, its technology falls considerably short in terms of performance versus that produced by its biggest and most formidable competitors – Illumina and Pacific Biosciences (PacBio). As thorough analysis by J Capital Research shows (https://www.jcapitalresearch.com/uploads/2/0/0/3/20032477/2017_12_14_ipo.pdf) the error-rate of Nanopore’s sequencers averages 5-10% vs. the <1% for Illumina. While PacBio’s devices average the same error rate as Nanopore’s, PacBio’s devices can be used multiple times until errors are reduced, something that’s not possible with Nanopore’s technology. This is because the errors of PacBio devices are random, while Nanopore’s are the result of some fatal flaws in the technology which repetition won’t remove.

Moreover a recent sell-side research report finds that to date, most of the improvement in the accuracy of the data generated by Nanopore’s devices has come from "user-coders generating more sophisticated data processing tools to extract information and scrub errors from the raw data", rather than from improvements to the inherent error-proneness of the technology itself.

Moreover, the technology is highly impractical due to what J Capital Research finds to be its unstable nature, need for refrigeration and short shelf life, all of which further plague its potential for commercialization. More specifically, this defeats the point of the MinION device which being very small in size, promises to allow any lay person to be able to put it to use in their everyday life. However, the unstable nature of the technology means that it isn’t actually portable. Instead, it would require the accompaniment of a mobile lab with refrigeration and uplinks for the masses of data that it produces.

Another important point to consider is the overall cost of sequencing through the use of such technologies. While Nanopore’s standalone devices cost substantially less than that of its competitors with MinIONs – its smallest devices, priced at $1,000, and the GridION X5 – a desktop device, priced at $135,000 vs PacBio device prices ranging from $350-750,000 and Illumina device prices ranging from $125-850,000, the cost of the actual sequencing and calculation of results is vastly greater when using Nanopore’s devices, counteracting any price advantage at the device level. More specifically J Capital Research estimates that the cost of sequencing a genome on an Illumina device is as low as $1,000 and $3,000 in the case of PacBio vs the astounding $90,000 when using Nanopore’s MinION.

The technical shortcomings of Nanopore’s devices are reflected in its financial performance to date with underwhelming revenues of only £14 million as of 2017. This is further confirmed by reviews from unsatisfied customers who point out the immature and unreliable nature of the technology, its low processing capabilities, error-proneness and ultimately higher cost vs that of PacBio and Illumina technology, confirming all the above analysis.

The most important point in all this, however, is the limited commercial value of the company and its assets, which puts Oxford Nanopore in particular danger given the competitive nature of the market in which it operates. Illumina’s acquisition of PacBio will put Nanopore at an even greater disadvantage to its competitors as Illumina is a highly profitable and cash generative business which gives it incredible firepower to continually invest in the development, improvement and ultimate commercialization of its DNA sequencing technology. This is in stark contrast to Nanopore, which according to J Capital Research as of the end of 2017 was burning cash at a rate of £5 million per month with a cash position of only £64M (this has been boosted by 2 funding rounds of a total of £150 million in 2018).

Despite its inferior technology and poor financials, Oxford Nanopore is wildly overvalued. The £1.5 billion valuation attributed to Nanopore by its most recent funding round and Woodford’s marked up valuation of the company at ~£1.4 billion, equate to a ‘17 EV/Revenue multiple of just north of 100x. This is in stark contrast to the ~12x ’19 revenue multiple that Illumina is trading on and the ~2-6.5x ’19 revenue range that PacBio traded at prior to the announcement of it being acquired by Illumina. Even the multiple at which Illumina is acquiring PacBio is a mere ~9.5x ’19 revenues.

To make these multiples comparable we would have to use Nanopore’s ’19 revenue multiple, yet not having such figures given the lack of disclosures by the company, we assume the best-case scenario to show the extent of the company’s overvaluation. Even the assumption of the trebling of the 2014 £14 million revenue figure by 2019 (i.e. to £42 million in revenues) results in a ’19 EV/revenue multiple of ~36x, assuming that WPCT doesn’t further mark up its stake in the company. In order for Nanopore to trade in line with peers (i.e. at a mid-teens revenue multiple) it would have had to increase revenues by more than 6 times within the span of 2 years, a scenario we deem highly unlikely given the inferiority of Nanopore’s technology to that of peers and its limited uptake to date.

•  Prothena

Prothena - a clinical-stage neuroscience company in the US focused on the discovery and development of novel therapies in the neuroscience and orphan categories, is a prime example of the partial materialization of the above described short thesis and the highly likely future trajectory of many of WPCT’s underlying holdings and WPCT itself.

On 23/04/18, the company announced the discontinuation of its development of an investigational antibody that would treat amyloidosis – NEOD001. This caused the company’s share price to fall by ~68% and resulted in WPCT having to mark down the value it previously attributed to Prothena. Woodford Investment Management as a whole owns ~29% of the company.

With NEOD001 discontinued, Prothena is left with compounds the majority of which are in the preclinical or discovery phases of development. The only drug with any promise is PRX002/RG7935 – a potential treatment for Parkinson’s disease, which is in phase 2 and being co-developed with Roche.

While Prothena remains a highly speculative bet on very early-stage compounds/drugs, we avoid making judgments on the value of its underlying compounds, instead using this as an example of the types of bets that WPCT tends to make and their largely unproven and speculative nature.

• Benevolent AI

Benevolent AI (“BAI”) makes a bold claim of being the “global leader” in artificial intelligence.

Source: Companies House Filings Annual Report 2016

BAI claims to be able to read research using its “propriety algorithms which can elude human understanding.  BAI does this by using its “bioscience machine brain”.

Source: Science

The science community is openly disparaging about BAI’s claims.

BAI published a research paper in 2017, and then rebranded it as marketing material in 2018 as it was met with ridicule from online science bloggers.

At a current valuation of £1.6 billion we believe BAI is also of questionable actual value.  Numerous transactions with WEIF are highly suspicious. See coverage by Share Prophets.

Conclusion: As shown above, the vast majority of WPCT’s top holdings are either greatly overvalued or highly questionable as businesses/entities. The high concentration of WPCT’s top holdings and their comprising of more than half of WPCT’s total portfolio, make the failure/mark-down of even a couple of these underlying holdings sufficient to drive the materialization of the above expounded short thesis.

Valuation

We note that the dire nature of Industrial Heat is likely emblematic of the rest of the portfolio.  If the 2^nd largest holding is so speculative, it’s reasonable to extrapolate.  What’s more, detailed analysis of Oxford Nanopore and Benevolent AI suggest that their valuations have been marked up to an unjustifiably high level in a desire to manipulate performance.

To value the trust, we first breakdown the top 10 holdings.  We generously assign only a 50% discount to the remaining companies in the top 10.

From there we apply the same discount to the remainder of holdings and arrive at a share price downside of -59%.

Risks

•  Listing of unquoted stocks at lofty valuations

There have been recent discussions of an Oxford Nanopore IPO over the next 12 months.  If WPCT’s biotech start-ups can be IPO’ed at lofty valuations as in the case of Autolus, this would imply the mark ups so far have been accurate and the fund would move back to par. 

•  Constant mark up of NAV

Since Woodford has discretion over WPCT’s reported NAV, this figure can easily be manipulated.

This risk is mitigated, however, by WPCT’s shares trading away from its NAV (as demonstrated by the 17% discount to NAV) as the market loses confidence in Woodford’s own valuation of their holdings. The more the short thesis materializes the less credible Woodford’s reported NAV will become, and the more detached it will be from WPCT’s share price.

•  Acquisition offers for any of underlying companies

Given the IP-heavy nature of many of the companies in which WPCT holds shares, an offer for a buy-out of any of these is not too remote of a scenario and could result in the further marking up of the stake in such a company as well as instilling more confidence in WPCT.

•  Trading up of the quoted portion of the book

Good share price performance of the larger and more mature listed businesses held by WPCT for whatever reason, would drive WPCT share prices higher with them. However, this risk is mitigated by the declining portion of WPCT’s portfolio which is held in these large listed entities.

Risks capped by investment trust structure:

However, total downside is capped to a move back to NAV which given the fact that valuations are already very high across multiple stocks is likely to be limited.  NAV is currently £0.95p and WPCT trades at £0.72p implying the shares could go up a maximum of 24% in a downside case where shares rerate back to par with NAV.

 Legal Disclaimer: This research report expresses my research opinions, which I have based upon certain facts, all of which are based upon publicly available information. Any investment involves substantial risks, including complete loss of capital. Any forecasts or estimates are for illustrative purposes only and should not be taken as limitations of the maximum possible loss or gain. Any information contained in this report may include forward-looking statements, expectations, and projections. You should assume these types of statements, expectations, and projections may turn out to be incorrect. This is not investment advice nor should it be construed as such. You should do your own research and due diligence before making any investment decision with respect to securities covered herein. The author has a position in this stock and may trade this stock.

Catalyst

Catalysts

• Further redemptions from WEIF

Further redemptions from WEIF would lead to its winding down and the forced sale of its underlying assets, many of which WPCT holds as well, especially after the swap deals with WEIF that it has engaged in. This could put the valuation of these holdings under further pressure as well as inviting increased scrutiny of their quality.

• Underlying unquoted holdings continue to burn cash, thus needing additional funding rounds

Most of WPCT’s early-stage unquoted holdings burn through cash at high rates, and have to date relied on additional funding rounds for additional cash injections in the majority of cases led by Woodford themselves. As Woodford Investment Management comes under more pressure from redemptions, inevitably having to downsize its funds, Woodford will find it much more difficult to meet the cash demands of its underlying holdings.

•  Better understanding by retail investors of nature of certain holdings such as Industrial Heat

Were retail investors, particularly such holders as Hargreaves Lansdown which holds ~23% of WPCT shares, better educated in the composition of WPCT’s holdings and the dubious nature of certain investments such as WPCT’s holding of Industrial Heat, they would be highly inclined to sell as the risks of holding WPCT shares would come to light.