Pop Quiz, Star Scientific Edition

Pop quiz hot shot.

You’re the management of Star Scientific (STSI) a company that supposedly has found the cure for Alzheimer’s in a compound isolated from nicotine called antabine.

The stock price for your company has tanked due to the failed hopes of winning a big legal settlement from Reynolds American (RAI) and that nagging issue of not really having a cure for Alzheimer’s.

Now your warrants are under water.

What do you do?

What. Do. You. Do?

As BuyersStrike! points out, you reprice those warrants and then enlist some stock touts to run a promotional campaigns for your stock of course.

Recently management and some investors rewarded themselves with a warrant repricing. The warrants, previously underwater, were kindly transformed into massively in-the-money securities. Free money for them, lots of dilution for shareholders. Not long afterwards, Patrick Cox (who has been touting the stock for some time) ramped up his promotional campaign, helped with a tout-assist by John Maudlin.

See the sales pitch from Patrick Cox that will make you chuckle after the jump.

The shameless, moronic, Patrick Cox – (STSI) (BuyersStrike!)

Why Would Netsuite Change its Renewal Agreement and When it Books Deferred Revenue?

In the second quarter of this year Netsuite (N) changed its renewal agreement and its timing of booking accounts receivable and deferred revenues from renewals.

During the second quarter of 2012, we updated the terms of our standard renewal agreement form so that the legal obligation to pay by our customers occurs upon execution of the renewal agreement rather than on their renewal date. Based on our existing policy of recording amounts that have been invoiced in accounts receivable and deferred revenue where the customer has a legal obligation to pay, invoices from these renewal agreements are now recorded in accounts receivable and deferred revenue upon execution of the renewal agreement rather than at the start of the renewal period. – Netsuite’s 3rd Quarter 10-Q

Why would they change their renewal agreement and book receivables and deferred revenue much sooner? One reason is you get to say bad-ass things like this during your earnings call

And we finished with a record deferred revenue balance, up 38% year-over-year. – Zachary Nelson during Q2 2012 earnings call.

Also, total deferred revenue grew at 40% year-over-year, the fastest growth rate ever since we became a public company. – Zachary Nelson during Q3 2012 earnings call.

Moving on to calculated billings. If you’ve done the math, you see that calculated billings, defined as revenue plus the change in deferred revenue, were $84.5 million for the quarter, up 35% over Q2 of last year. – Ronald Gill during Q2 2012 earnings call.

As you can calculate from the financials published in the press release, calculated billings, defined as revenue plus the change in deferred revenue, were $85.4 million for the quarter, representing an increase of 33.8% over the third quarter of last year. – Ronald Gill during Q3 2012 earnings call.

The Cynical Reason

The other reason, the more cynical one, is when the value of your stock options and the vesting of your performance units are dependent on a higher stock price and higher operating cash flows you’re willing to pull forward from future quarters the booking of deferred revenues and accounts receivables. Especially, as they pertain to key growth metrics that you like to highlight in your earnings calls.

From Netsuite’s Proxy filed on April 20, 2012 highlighting their 2011 performance compensation.

The other 50% of the PSUs was based on TSR [Total Stock Return] performance measured against a group of comparable peer SaaS companies chosen in advance. TSR performance for these purposes was calculated using the average closing price of the common stock during each of the months of December 2010 and December 2011 to reduce the potential one-day variability impact of tying the calculation to a one-day closing price at the end of the year. Therefore, over the one-year measurement period, our stock price grew at an average rate of 72.5% while the average growth rate of our peer group companies was at 13.8%, resulting in achievement of the TSR component of 217.6% of target, however payout was capped at 175%.

The other half of Netsuite’s performance share units for 2011 were based on financial metrics. The financial metric portion is further broken down into the following: 60% on a GAAP revenue target, 15% on a Non-GAAP operating margin target, and 25% on a Non-GAAP operating cash flow target. The Non-GAAP operating cash flow target is measured the same as GAAP operating cash flow.

The excerpts above were for 2011 but if the 2012 compensation package is similar to 2011, and Netsuite’s 3rd quarter 10-Q lends to this view, then the majority of the management’s performance share units are positively affected by the change in the renewal agreement.

Tesla Motors’ Words, not Mine

I want to clarify a few tweets of mine from yesterday regarding Tesla Motors (TSLA) and their loan with the Department of Energy.


I know. I spelled covenants wrong.

The tweet above is Tesla Motors (TSLA) words not mine. From Tesla’s latest equity offering prospectus.

Based upon our current financial forecast, we currently anticipate that if we do not raise the proceeds anticipated from this offering and do not otherwise adjust our operations accordingly or amend the DOE Loan Facility, we may not be compliant with the current ratio covenant for the quarterly period ending March 31, 2013.

If Tesla Motors can’t meet its financial covenants they’ll need waivers from the DOE to avoid being in default. Surprise surprise, Tesla just ironed out another amendment, 4 total now, to its Department of Energy Loan in which the DOE has waived Tesla’s current ratio requirement.

Tesla said it received a waiver Sept. 24 from a requirement in the previous loan agreement to maintain a specified current ratio (TSLA) of assets to liabilities, which measures a company’s ability to repay its debts in the next 12 months.

Tesla Told to Speed Repayment of U.S. Electric-Car Loan (Bloomberg Businessweek)

The next two tweets were inspired by Tesla’s equity offering prospectus too.

Tesla’s words.

For the quarters ending September 30, 2013 and December 31, 2013, we currently anticipate that without taking advantage of additional revenue opportunities or making adjustments to our spending, we expect that we will need to seek an amendment from the DOE to modify the fixed charge coverage ratio covenant. Moreover, we currently anticipate that without raising capital in addition to this offering, we would need to seek an amendment from the DOE to modify the total liabilities to stockholder equity covenant for the quarters ending March 31, 2014 and the two subsequent quarters.

What is Netsuite’s Management Incentivized to Do?

While reading Netsuite’s (N) latest 10-Q, I came across this little nugget on incentives.

These PS grants were equally divided into two tranches: shares that vest based on the Company’s performance in 2012 and 2014. The PS vesting is contingent upon the Company meeting certain company-wide revenue and non-GAAP operating margin performance goals (performance-based) in 2012 and certain company-wide revenue performance goals in 2014.

Source: Netsuite 10-Q ending 6-30-2012

What is Netsuite’s management incentivized to do?

Maybe aggressively build out their sales force? Then compensate the sales team with stock awards so you can add back the stock-based-compensation to your non-GAAP earnings while your GAAP earnings remain negative? Maybe?

I’ve seen this somewhere before.

*cough* Salesforce.com *cough*

Maybe Student Transportation Should Go to School with its Kids

Student Transportation (STB) already has some problems with math like covering its dividend payments with operating cash flow. Now it looks like Student Transportation is having problems properly calculating EBITDA as Ben Strubel of Strubel Investment Management points out.

The correct way to calculate EBITDA is to start with net income and add back only interest, taxes, depreciation, and amortization. You are not allowed to add back other items, such as foreign exchange gains or losses, stock based compensation, or any other items and call the measure EBITDA. You can, however, add back other items if you call the measure something other than EBITDA, such as “Adjusted EBITDA” as suggested by the SEC.

Below is the reconciliation of net income to EBITDA that Student Transportation provided to investors and the public in the aforementioned press release. I have drawn a red box around items that are prohibited from being included in EBITDA calculations as per SEC Regulation G.

Image courtesy of Strubel Investment Managment.

The kicker?

It looks like Student Transportation can’t even follow its own guidelines when it comes to calculating EBITDA and reports two different numbers.

Read the full article after the jump.

Is Student Transportation, Inc. Improperly Calculating EBITDA in Violation of SEC Regulation G? (Strubel Investment Management)

Lessons From History

Some great advice from The Long Short Trader on learning from past financial fraud, Sunbeam.

LST is currently taking a look at a few companies that may have material accounting and/or fraud problems. It occurred to LST that in a few of these cases, past may be prelude to future. And so LST took a look at Sunbeam and a few others. Here are a few things that got LST’s attention, in the case of Sunbeam:

  • Large discrepancies between reported earnings and cash flow from operating activities (“CFFO”) matter;
  • If management’s explanations for differences between earnings and CFFO do not pass the sniff test, there is a problem.
  • CFFO less some portion of cash flow from investing activities is a much more reliable measure of true earnings, than reported earnings… this seems true before and after the fraud.
  • A 10% overstatement in revenue can revise earnings downward at least 50-60+% , depending on how much operating leverage there exists;
  • Income taxes payable on the income statement is as real as earnings is…it’s not.
  • Even when there’s no outright cash fraud, the cash & cash equivalent balances may not be accurate.
  • Cash flow from financing activities seems the most difficult to game. Perhaps it is the only statement (in non-financial/banking companies) one can somewhat anchor to, and maybe even “trust and verify” rather than “verify only”
  • Fraudulent discrepancies between earnings and CFFO,even after a restatement, seem predictive of very material hits against earnings and CFFO in future periods. See Sunbeam’s 1998 numbers to see for yourself.
  • And there’s a lot more.

Follow the link below to see Sunbeam’s reported fraudulent financial statements compared to its adjusted/corrected financial statements.

Sunbeam Accounting Fraud: A Look at the Before and the After (The Long Short Trader)

Zagg Inc. and The SEC, is There an Investigation Going On?

Worthless Pennies the author of the Seeking Alpha instablog “The Worthless Pennies” believes so. After requesting a Freedom of Information Act pertaining to any SEC investigations, past and present, regarding Zagg Inc. (ZAGG) and the acceptance of his request, Worthless Pennies did not receive any information. After pestering the SEC he finally received a reason for the delay and a potential clue to an ongoing SEC investigation.

“records responsive to your request were subject to several confidential treatment requests. Until our negotiations with the confidential treatment submitters is complete, we cannot review or release of any of those records. Once our negotiations are complete we will be able to make a final determination concerning the records.”

This is a very interesting and important response for several reasons. First off, if the records that are being referenced were not pertaining to an investigation by the SEC then they would not be “responsive” to my request. The vast majority of FOIA requests submitted to the SEC come back simply with a “no records” reply (7,866 out of 11,562 FOIA requests received that reply from the SEC in 2011). The second reason that the response was important and interesting can be found in this law firm’s report on how to handle SEC investigations:

http://www2.americanbar.org/calendar/business-law-section-2011-spring-meeting/Meeting%20Materials/2149.pdf

In the report they recommend that companies that are the target of SEC investigations:

“Remember to request confidential treatment under the Freedom of Information Act for documents that are produced to the SEC.”

Source:

Is ZAGG The Target Of An SEC Investigation? (The Worthless Pennies)