By Damion Rallis, Senior Research Associate
While the share price at Aspen Technology (AZPN) continues its steady and impressive climb - up more than 50% since last November - a closer look at the company's governance profile reveals several troubling indications that Aspen could be due for a reversal. Not only has the software solutions company been mired in a never-ending swirl of SOX 404 Violations dating back to 2005, but a slew of other troubling events and recent insider sales by its CEO would suggest that Aspen's overall "C" ESG rating is at risk of falling further.
The investment world is abuzz this week from revelations out of Hewlett-Packard that Autonomy, a British software maker it acquired last year for $11.1 billion, had engaged in "serious accounting improprieties." HP claims that Autonomy inflated its sales, fooled multiple auditors, and ultimately cost HP more than $5 billion as it was forced to take an $8.8 billion accounting charge due to their "outright misrepresentations." This latest accounting scandal led the New York Times to surmise that "the claims made on Tuesday suggest that there is something about the nature of the software business that makes it easier for executives to indulge in questionable accounting." The heart of the issue, it seems, was misclassified revenue. What does this mean for software solutions company Aspen Technology? It means that it's time to take a closer look and not merely trust a surging share price.
At quick glance, Aspen Technology's middling "C" ESG Rating and "Average" AGR® Rating appear not much to pause over, but sometimes spending a bit of time with a company's accounting and governance profile, even with limited analysis, can reveal material defects under the surface. For instance, Aspen has been flagged for Revenue Recognition issues as a component of our AGR Rating, which is a comprehensive measure of accounting quality and corporate integrity, based on an extensive evaluation of metrics which study financial results and corporate behavior. Specifically, Aspen has been flagged for Accounts Receivable/Sales as accounts receivable build-ups can signal a broad range of revenue recognition issues. High ratios of receivables to sales, particularly in combination with inventory build-ups, underfunded unearned revenue accounts, or other evidence of account manipulation can in total indicate high risks of revenue recognition problems. At Aspen, the company's current ratio of total receivables to total revenue is 0.318, nearly double the industry's ratio of 0.168.
Furthermore, as one begins to scan Aspen's long list of ESG Events, the story truly starts to come into focus. The trouble began in October 2004 when the company announced that it had received a subpoena from the United States Attorney's Office requesting documents relating to transactions from 2000 to 2002. The investigation charged several Aspen executives with violations of the Securities Exchange Act. From that point on, the company has been on quite a roller coaster ride. One month after the subpoena was announced then-CEO David McQuillin resigned at the board's request, followed by then-Chairman Lawrence Evans who retired in January 2005. In February 2005, Aspen's Audit Committee identified sixteen transactions entered into during fiscal years 2000, 2001 and 2002 that were not accounted for properly.
As the months and years began to roll by, Aspen Technology found itself in an untenable position: it seemed incapable of maintaining effective internal control over its financial reporting. As a result, the company has been repeatedly hammered with SOX 404 violations each and every year since 2005. The trouble began with the company's fiscal 2005 annual report, when it revealed six material weaknesses that truly should give investors pause:
- inadequate staffing and ineffective training and communication within our accounting and finance organization;
- ineffective revenue recognition controls;
- inadequate financial statement preparation and review procedures;
- ineffective and inadequate controls over the accounts receivable function;
- inadequate controls over the accounting for taxes; and
- inadequate controls over bank accounts.
In 2006, the company reported such deficiencies as "inadequate and ineffective controls over accrual of goods and services received," while in 2007 it reported "inadequate and ineffective controls over the recognition of revenue." And so on and so forth: in 2008, Aspen reported "inadequate and ineffective controls over the accounts receivable function;" in 2009 there were "inadequate and ineffective monitoring controls;" in 2010 there were "inadequate and ineffective controls over the periodic financial close process;" in 2011 the company reported "inadequate and ineffective controls over the recognition of professional services revenue;" and finally, in 2012 the company still reported "ineffective controls over income tax accounting and disclosure." Bear in mind, this list merely represents examples of the company's lack of accounting controls as there were numerous other deficiencies that it simply could not control.
As a result of these ongoing accounting shortcomings, Aspen Technology faced SEC investigations, internal investigations, class action lawsuits, financial restatements, delinquent filings, auditor changes, delistings from the NASDAQ, and a new CFO or two. In short, the company simply could not get its act together. In the meantime, shareholders were not shy with their discontent. In 2010, nearly 16% of voters withheld votes for Audit Committee chair Gary Haroian while over 30% did so for Compensation Committee chair Donald Casey. Then, in 2011, a majority of Aspen shareholders (over 53%) withheld their votes for long-tenured director Joan McArdle. However, Ms. McArdle remains on the board since the company has a plurality election standard without a resignation policy. She would have been reelected even if she had received only one vote of approval. Directors who receive a majority withheld votes are allowed to remain on the board, are a clear repudiation of shareholder interests.
Aspen Technology's governance profile includes other glaring examples of practices that not only fail to benefit its shareholders but also serve to reflect our worsening view of the company's long-term sustainability risk. Since March, the company's ESG percentile score has declined by nearly 16% and sits right on the cusp of an overall "D." As an example of our concern, the company's board is classified, which means that each director is not subject to shareholder election on an annual basis. As a result, this structure makes it substantively difficult and lengthy to gain control of a board majority. In addition, the company has charter and bylaw provisions that would make it difficult or impossible for shareholders to achieve control by enlarging the board or removing directors and filling the resulting vacancies. The combined effect of these mechanisms is to effectively reduce shareholder oversight.
Board insulation by design may contribute to policies which can further damage shareholder interests. Aspen's executive compensation practices reflect this possibility. First, the company targets annual cash compensation ranging from the 60th to the 75th percentile of its peers and equity compensation ranging from the 50th to the 75th percentile of its peers. This policy indicates that it is the company's specific intention to set compensation standards well above median levels. As a matter of practice, standard performance should logically be targeted at median levels. Also, the company does not have a clawback policy which would allow for the recovery of executive compensation in the event of fraud or financial restatements. The bulk of remuneration paid to CEO Mark Fusco for fiscal 2012 consisted of compensation elements not tied to performance-based targets. Of his total summary compensation of $4,107,713, his salary was $600,000 and his equity award totaled $2,752,000 and consisted merely of stock options and restricted stock units, both of which vest simply over time without performance-contingent criteria. Moreover, Mr. Fusco also realized almost $5.6 million on the exercise of options and the vesting of restricted stock in 2012. Equity awards should have performance-vesting features in order to assure proper alignment with company performance. Additionally, market-priced stock options in many cases simply reward executives for market correlated stock appreciation, rather than any aspect of individual performance. In addition, executive officers are eligible to receive up to 25% of their annual bonus target based on mid-year evaluations. Short-term incentive awards should be based on at least one-year performance periods, as anything less than that may motivate executives to focus on extreme short-term growth.
Despite the foregoing, what initially caught our eye with the software solutions company is the high number of insider sales from its CEO since last Wednesday. Over the past six days, Mr. Fusco has sold a total of 1,205,641 shares for over $31.3 million. While we are loath to make assumptions based on a high amount of stock trades-there are any number of factors that could force an individual to liquidate his stockholdings-we note that since Mr. Fusco is only 51 years old and has been Aspen's CEO for about 8 years that it does not appear that he is merely cashing out for retirement. Moreover, since February, the CEO has sold nearly $49 million worth of equity compared to only $1.3 million in 2011.
Does Mr. Fusco know something we don't know? Has the company's bewildering inability to get its accounting in order finally caught up with it? Could revenue recognition problems like the ones at HP be rearing their ugly head at Aspen? Sometimes a share price is merely share price and a company's financial statements do not tell the whole story. At GMI Ratings, there are a myriad of other indications that the company is heading in the wrong direction. For instance, GMI Ratings' Litigation Risk model shows that Aspen's litigation risk continues to increase, having dropped from 44 in August 2011 to its current score of 21, which places them in the 21st percentile of all companies in North America, indicating higher shareholder class action litigation risk than 79% of all rated companies in this region. In any case, given the recent news at HP and Aspen's long list of accounting failures, this is certainly a company that we're going to keep our eye on.