Seeking Alpha
Alan Brochstein, 420 Investor (1,292 clicks)
Contrarian, growth at reasonable price, management change, cannabis stocks
Profile| Send Message| ()  

Editors' Note: This article covers micro-cap stocks. Please be aware of the risks associated with these stocks.

Most investors who choose to pursue stocks that trade on the pink sheets or OTC markets know that they are speculating. As I have said before, there is nothing wrong with speculation, as long as you are smart about it. In a part of the market where the deck already seems stacked against investors due to limited disclosure, here's something you can do to avoid getting your pocket picked: Avoid companies with convertible preferred stock. I will explain what it is, how it can burn you and then give a few examples.

What is Preferred Stock and Why You Should Care

Investopedia defines "preferred stock":

A class of ownership in a corporation that has a higher claim on the assets and earnings than common stock. Preferred stock generally has a dividend that must be paid out before dividends to common stockholders and the shares usually do not have voting rights.

The precise details as to the structure of preferred stock is specific to each corporation. However, the best way to think of preferred stock is as a financial instrument that has characteristics of both debt (fixed dividends) and equity (potential appreciation). Also known as "preferred shares".

While this definition works well for REITs and banks, which tend to use this form of financing, it really doesn't suffice for penny stocks. The preferred is indeed a different class of ownership, but they typically do not pay dividends (as penny stocks don't usually have cash to use for dividends). I have seen some issues that have super-voting rights, meaning that the shares entitle the owner, typically an insider, to control the company even without holding the majority of the common stock. The preferred stock that I am addressing is a financing tool used typically to create common shares.

As my real examples will demonstrate, insiders are able to understate the amount of shares outstanding by using convertible preferreds. For example, a company may have 100mm shares trading at $1, implying a $100mm market cap, but they might have 10mm shares of preferred stock convertible into another 50mm common shares at the discretion of the holder. In this example, the company's fully diluted shares are 150mm.

Disguising the true number of shares is beneficial to a company because it can lead to a higher price than if investors are truly aware of the number of potential shares. Market services like Yahoo tend to base their information on common shares outstanding. Often the preferred shares, if converted, can represent a multiple of the common shares. It is especially important to be aware if the authorized shares are high enough that full conversion is possible without a shareholder vote. The bottom line is that a company can be worth a lot more than its common shares outstanding suggest or that most investors realize.

Another issue is that the preferred stock isn't a marketable security. In two of my real examples, I will show how the companies have used this to allow debt to the company to be converted to preferred shares at a big discount to their true value. The subsequent conversion to common stock results in a massive windfall to the lender to the company who is often an insider. I am not a securities lawyer and don't have a clear view on the legality of this practice, but it strikes me as unethical, to say the least.

Example 1: AVT Inc. (OTCPK:AVTC)

I wrote about AVT a couple of months ago and described this exact scheme. Since that article, the company has still not filed its Q1 filing, as it has changed auditors again. The company was previously an SEC filer. In its 10-K, it describes itself as having 11.4mm common shares outstanding at year-end. It also describes its convertible preferred stock as it discusses insider ownership:

(7) Worth, Inc. holds 12,762 shares of our common stock and 2,450,598 shares of our of our Series A Convertible Preferred Stock. Each share of our Series A Convertible Preferred may be converted into six (6) shares of our common stock. Assuming all 2,450,598 shares of Series A Convertible Preferred stock held by Worth, Inc. were converted into common stock, Worth, Inc. would hold a total of 14,703,588 shares of common stock which is greater than 128% of our issued and outstanding shares of our common stock as at December 31, 2012.

The first observation is that the fully-diluted share count is 26.1mm shares. The second observation is that it's important to understand exactly who is "Worth, Inc." and what is going on. As I explained in my previous article, Worth, Inc. is controlled by its sole owner:

Worth, Inc. is owned by Jon Illingworth, the father of our founder and Chairman, Shannon Illingworth.

There is a related-party transaction that tells us what the real problem is:

A company, that is a major shareholder and related party, loans the Company funds to assist in cashflow. There is no formal agreement between the parties. Advances totaling $365,000 were received from the related party for the year ended December 31, 2012. Payments totaling $183,741 were made to the related party. A $125,000 payment was made through the issuance of shares of common stock. At December 31, 2012 and December 31, 2011, the Company owed the related company $129,093 and $62,259, respectively.

I think that the above was a typo when it said "common stock", as the same filing later said:

For the quarter ended September 30, 2012, we issued Worth, Inc. a total of 125,000 shares of our Series A Convertible Preferred stock valued at $1.00 per share or $125,000 as partial payment of note.

This is a real problem for shareholders, as they say that the stock was valued at $1 per share yet it was convertible to 6 shares of common stock. During Q3, the lowest quoted price of AVTC was $1.15, and the high was $1.70. AVTC paid $125K debt off with stock valued between $862K and $1.275mm.

Earlier in the year, Worth Inc. converted a significant number of preferred shares into common shares:

On April 4, 2012, a preferred stock shareholder converted 82,981 preferred shares into 497,888 shares of common stock.

Of note, at year-end, Worth, Inc. held just 12,762 shares, so one can presume that they were sold into the open market.

Earlier, I discussed voting rights, and the AVTC preferred stock not only has the rights to dividends potentially as well as liquidation preference (i.e. first dibs on anything following bankruptcy), but it also has voting rights. Worth, Inc. controls the company but gets to sell stock, apparently without disclosing the sales. What makes this terribly unfortunate for the shareholders is that they get diluted but the company fails to raise the funds. This is important because the company needs capital. Instead, the wealth is transferred to the father of the Chairman.

With AVTC, we have not only an understated market cap (Yahoo Finance shows $27mm, failing to incorporate the preferred shares), but we also have games being played with the convertible preferred stock. Specifically, the company has issued these shares in exchange for debt repayment to the father of the Chairman at off-market levels. A more complete review of the history of the company suggests that the preferred stock wasn't adjusted for a reverse split and that the company used preferred stock to pay for a Mexican restaurant. In sum, in my view, millions of dollars have been diverted from shareholders due this security.

Example 2: Hemp, Inc. (OTCPK:HEMP)

I reviewed Hemp, Inc. in March and found a number of reasons for concern, saying it was priced "too high" at $0.06. My continued diligence suggests several concerning issues (and I expect that the stock will trade below $0.01 soon), but here I will update what I shared then about share issuance with more current information. At the time, I was working with the 9/30 filing, but the company has provided an annual report as well as a Q1 report.

The most recent data (from the Q1 report) shows the number of common shares outstanding as well as two different preferred stocks:

(click to enlarge)

What's really interesting is that the preferred shares jumped up after Q1, as the filing indicates that as of 3/31 the amounts outstanding were 236.7mm and 165.8mm, respectively. This could be a mistake, as the company's filings are filled with them, including a misspelling of CEO Perlowin's name ("Perloin"). So, not surprisingly, most services report the current market cap based on the 1.43 billion shares. Yahoo Finance, for example, indicates that it is $13.3mm. Let's get the real share count though. The Preferred converts at 2.5:1, while the "K" converts at 10:1. This suggests 1.25 billion common shares from the preferred and 2.5 billion from the "K", or an additional 3.75 billion shares. When added to the 1.43 billion common shares, it totals 5.18 billion shares. Note that only 3 billion are authorized, so not all of the preferred shares can be converted at present.

Here are the transactions involving the preferreds in Q1:

20,000,000 PREFERRED CONVERTED INTO 50,000,000 COMMON IN QUARTER ENDED 3/31/13

12,555,555 PREFERRED K CONVERTED INTO 125,555,555 COMMON IN QE 3/31/13

In Q1, the stock traded between $0.03 and $0.15, with a lot of volume near the highs. At $0.10, the 175mm shares roughly, if sold, would have reaped $17.5mm. Even at $0.06, the value was $10mm.

Here are the 2012 transactions:

193,836,430 PREFERRED K SHARES ISSUED FOR DEBT IN 2012; BRUCE PERLOWIN

Remember, the "K" shares convert 10:1. So, this is effectively 1.9 billion shares! Yowsa! During 2012, the amount of the loans from Perlowin to the company decreased from $1.96mm to $671K. The K shares covered the entire reduction, so, these shares, convertible to 1.9 billion shares, are worth less than $2mm??? Wow! In Q1, the company lost $334K on about $426K in sales, and Perlowin loaned them more money (about $500K). Not a bad gig for Mr. Perlowin! Hopefully, for him, with a basis of 1/10th of a penny, he can keep this up.

Example 3: MedBox, Inc. (OTCPK:MDBX)

I have not discussed this stock in depth like the other two, and I don't really have a complete view of the company. As such, I am focusing only on its use of preferred stock. In the most recent quarterly filing, Note 7 states:

In November 2011, the Company issued 6,000,000 of zero par value convertible restricted preferred stock to the founder of subsidiary Prescription Vending Machines, Inc. and also a shareholder of the Company. This preferred stock can be converted from 1 ("one") restricted share to 5 ("five") restricted shares of common stock. In October 2012, 3,000,000 preferred shares were returned to the Company and cancelled.

The company is quite clear in the most recent disclosure regarding insider ownership and bases it on the amount of shares as if the preferred stock was converted. The number of common shares outstanding as of 3/31 was 14.7mm, but if the preferred stock was converted, then it jumps to 29.7mm (3mm preferred shares at 5 shares of common per 1 share of preferred). Yahoo Finance lists the market cap as just $348mm (based on 14.33mm shares, which is outdated). Seeking Alpha has it incorrect too, listing it as $358mm. Investors Hub lists it as $361mm. Unlike the other two companies I discussed, there haven't been conversions, but investors should be aware of four issues:

  1. The "real" market cap is $720mm (29.7mm shares at $24.25), which is quite high relative to any financial measure of the company
  2. The company is authorized to issue 7mm more shares of the preferred stock and its common stock authorization is 100mm shares
  3. The information in the Q1 filing differed materially from the way it was presented in the annual report, with the way the ownership is characterized changing dramatically.
  4. The audited income statement appears to be incorrect in its EPS assumption, as the $0.02 2012 EPS are based only on the common shares and not "fully diluted" (note: this may be in accordance with GAAP, but it overstates the true earnings of the company)

For those interested in MDBX, founder Vince Mehdizadeh issued a press release dated 7/29/13 announcing his vindication regarding a legal issue.

Conclusion

Penny stocks require extra diligence. I have shared yet one more thing that investors need to investigate before buying: Convertible Preferred Stock. If the company has it, it's important to quantify it so that the real market cap of the company is understood. Additionally, if there are conversions to common stock, there could be significant insider selling taking place.

Source: Avoid This 'Preferred' Way To Pick Pennies From Your Pocket