This article outlines recent events in Ebix (EBIX): from the withdrawal of the $20 offer from an affiliate of Goldman Sachs to the information revealed in the June quarter conference call. I believe there is currently 100% upside in the share.
Let me start by saying I hate legal documents. If I had to choose between a dentist's chair coupled with Justin Bieber's music versus reading legal drivel, point me to the chair. At least there the drill's noise would dull the pain in my ears, whereas there would be no respite from the stream of indecipherable English in the documents.
However, to understand Ebix's share price, one is obliged to wade through their legal battle, which has become inextricably linked to a spate of internet allegations and anonymous articles by short sellers.
This article attempts to unravel the legal imbroglio (in as far as it's possible) and to illustrate the upside beyond. My conclusion is based on piecing together the mosaic from the 2Q Conference Call that took place on 9th August. The Seeking Alpha transcript can be found here. There is now enough evidence to conclude the entire SEC investigation and charge of intentional misconduct are founded on two anonymous articles on Seeking Alpha, and there is evidence that these articles were materially erroneous and misleading. More on that below.
First the numbers in the second quarter earnings report for 2013
Ebix generated $51m in revenue for the June quarter, a YOY increase of 7%. The operating margin for Q2 2013 was 37.8% as compared to 37.1% in Q2 2012. The operating margins in Q2 2013 were positively impacted by a $5.8 million gain from the reduction of the earn out accrual from PlanetSoft, while being negatively impacted by certain legal and extraordinary operational costs, adding up to $4.5 million in Q2 of 2013. The company was also negatively impacted by the impact of lower initial operating margins from some businesses acquired in 2012 and 2013 as compared to their existing operations. EPS actually came in 1 cent higher than consensus, at 35 cents per share.
This is a very respectable performance when viewed in the context of probably the worst negative publicity faced by any company in the second quarter. Granted revenue was $1m shy of consensus, but it could have been seriously compromised.
When asked about the distractions the company faced due to the negative publicity and legal battles, the CEO replied:
Robin Raina - Chairman, Chief Executive Officer and President:
"Jeff, that's a great question. I think we're all positive people here at Ebix, and so I want to focus on the positives of where we are today. So having said that, these have been challenging times. I think it doesn't help our cause when our customers get to read certain stuff. Yes, there were a few challenges. At the same time, I will tell you this with absolute clarity, we have not lost any client because of any reason like this. Certain large deals got delayed. We had some large deals that we were in the process of negotiating, we were at the last stages and now we had to go in for discussions with compliance, with their legal and so on. And the good news is, we're starting to move those along and the good news is that most of our clients have been dealing with us for such a long time and we were able to reassure them and we have been able to move things back again. But yes, it was -- it has been a bit challenging."
The major concern in the earnings release was on cashflow. Ebix has historically demonstrated an excellent track record of cash conversion (cashflow from operations as a percentage of net income); the figure has hovered around 90-110% for every recent quarter, standing at 103% for the first 6 months to 2012. For this quarter it fell to 78%, the lowest in the past 8 quarters.
There were some exceptional cash items, one unsurprising one being a $4.5m legal bill (this was offset on EPS by a reversal of an unearned payout, but the bill payment impacted cashflow), as well as a $2.5m prepayment for Indian tax (relating to securing a low tax rate for 2015 onwards). Nonetheless there clearly was some slippage in the tightly run ship. I hold hope that the flapping sails will be promptly tightened, as stated by the CFO during the CC:
Robert Kerris, Chief Financial Officer, Principal Accounting Officer, Senior Vice President and Corporate Secretary:
"Our net operating cash flow in the second quarter 2013 was $10.6 million, a decline from $14.3 million from Q1 2013 and $21 million for the same quarter in 2012, due primarily to lower operating income net of noncash items. Our cash generation was less in recent quarters owing to several of the items we already talked about. Historically, for the last 2 years, Ebix has generated net operating cash flow nearly equal or sometimes surpassing net operating income. Cash remains one of the most important financial metrics of how Ebix runs its business. And except for added legal expenses, we will strive to return to that ratio in future quarters."
The Legal Imbroglio
The issue first arose in March 2011, when an article appeared on Seeking Alpha titled "Ebix Not A Chinese Fraud But A House Of Cards Nonetheless-part-I". There were actually 3 parts to this allegation, (Part II and Part III) . The author, under the name of Copperfield Research, disclosed his short position but remained anonymous. This short thesis of 3 articles are the only articles the author has ever written on Seeking Alpha.
Ebix received a class action suit based on the allegations in the Copperfield articles. This excerpt is from their 2011 Annual Report, page 17:
Between July 14, 2011 and July 21, 2011, securities class action complaints were filed against the Company and certain of its officers in the United States District Court for the Southern District of New York and in the United States District Court for the Northern District of Georgia. The complaints assert claims against (I) the Company and the Company's CEO and CFO for alleged violations of Section 10(b) of the Securities Exchange Act of 1934 (the "Exchange Act") and Rule 10b-5 promulgated thereunder and (ii) the Company's CEO and CFO as alleged controlling persons. The complaints generally allege false statements in earnings reports, SEC filings, press releases, and other public statements that allegedly caused the Company's stock to trade at artificially inflated prices. Plaintiff seeks an unspecified amount of damages. The New York action has been transferred to Georgia and has been consolidated with the Georgia action, now styled In re: Ebix, Inc. Securities Litigation, Civil Action No. 1:11-CV-02400-RSW (N.D. Ga.).
Subsequent to this shareholder class action suit, there have been three derivative complaints brought by certain shareholders on behalf of the Company, which name certain of the Company's officers and its entire board of directors as Defendants. These are known as Nauman vs Raina, Spagnolla vs Bhalla, and Hotel Trades Council and Hotel Association of New York City, Inc. Pension Fund v. Raina.
Although Ebix attempted to dismiss the class action suit, it was denied in September 2012.
As seen from the chart below, Ebix shares plummeted from $28 to $15 in a space of months following the Copperfield Report. It staged a halting recovery in 2012, aided by impressive earnings for the following quarters.
On November 5 2012 Bloomberg published an article stating that EBIX was the target of an ongoing SEC probe into its accounting practices, citing four anonymous sources. The SEC has not confirmed nor denied these allegations, while EBIX's CEO responded immediately stating:
"The Ebix senior management team has not been advised of nor is it aware of any SEC investigation regarding the Company's previous filings. We stand behind the accuracy of our public filings. The Bloomberg article is inaccurate and misleading in many respects and we intend to evaluate all avenues of recourse."
At that point Ebix was correct, that there was no SEC probe. One did emerge later however, as the company was issued a subpoena by the SEC on December 3 2012. This obviously leant credibility to the short thesis, and investors were now listening. However it's crucial to examine the substance of the short allegations rather than their ability to disclose confidential probes. More on that below. As a result of that article, EBIX share dropped by 27% in a week and stayed around $15 entering 2013.
In March 2013, a new short thesis appeared, this time under the name of Gotham City Research. An article appeared on Seeking Alpha on March 7, "Ebix All Distraction No Clarity". Here again, the anonymous author has published 3 articles on Seeking Alpha, all with the sole focus of alleging impropriety in Ebix's accounts.
On April 16, 2013 the company received another subpoena from the SEC. From the risk factors section of the recent CC:
"...in connection with the conduct by the SEC of a non-public fact-finding inquiry and investigation and seeking documents relating to the issues raised the matter styled In re: Ebix, Inc. Securities Litigation , and in an online news article based on unnamed sources, published on November 3, 2012."
On May 1 an affiliate of Goldman Sachs bid $20 for each Ebix share. This suggested that the new SEC subpoena was not particularly grave, and may well have been to try and establish how and why a confidential non-public inquiry had been made public. A number of class action lawsuits were initiated, claiming the price was too low. Ebix's price rose to just below the $20 level.
On June 19 the Goldman bid was withdrawn. From the relevant press release:
"The decision to terminate the merger agreement was the result of a letter received by the Company on June 14, 2013 from the U.S. Attorney for the Northern District of Georgia that it had opened an investigation into allegations of intentional misconduct that had been brought to its attention from the pending shareholder class action lawsuits against the Company's directors and officers, the media and other sources. The pending shareholder class action lawsuits and an SEC investigation involving the same subject matters as these lawsuits were previously disclosed by the Company in its periodic reports filed with the SEC."
The share price halved to around $10 and has stayed there since.
Moving into the announcement of the second quarter's earnings (August 9), investors were still unsure about the seriousness of the SEC investigation and the new charge. After all, Goldman walked away from the deal, and the $45m cancellation fee was waived. This offer was made with full knowledge of the SEC probes of December 3 2102 and April 16, 2013. What precisely had been uncovered and what investigation did it relate to?
The nature of the new developments was not clear. As stated by Mr. Pavan Bhalla, Chairman of the Special Committee of the EBIX Board of Directors on June 19:
"We are committed to fully cooperate with all the regulatory authorities, as they conduct their investigations and believe that the allegations in the class action lawsuits, which we have understood to form the basis of these investigations are without any merit."
In terms of legal proceedings there were 3 separate issues going into the earnings call:
- the class action suit above. What new disaster had been uncovered?
- an action known as Isaac vs Ebix, where the owner of Peak, a company acquired by Ebix, claimed he was short-changed by $1.5m, in that his company had achieved its earnout but Ebix denied this. Might this investigation have revealed a massive shortfall in internal controls and/or accounting impropriety?
- an action by Microsoft that claimed overuse of its software, for which Ebix had not paid license fees. Here, there was the possibility that Ebix had incorporated Microsoft code in its own software and there might be a large retroactive charge for the underpayment of licensing that pertained not to Ebix's own internal use, but to the software Ebix licensed to its clients.
For the same of completeness, following is the entire Legal proceedings section of Ebix's second quarter 2013 release (See what I mean by preferring the dentist's chair):
Between July 14, 2011 and July 21, 2011, securities class action complaints were filed against the Company and certain of its officers in the United States District Court for the Southern District of New York and in the United States District Court for the Northern District of Georgia. The complaints assert claims against the Company and the Company's CEO and CFO for alleged violations of Section 10(b) of the Securities Exchange Act of 1934 (the "Exchange Act") and Rule 10b-5 promulgated thereunder and (ii) the Company's CEO and CFO as alleged controlling persons. The complaints generally allege false statements in earnings reports, SEC filings, press releases, and other public statements that allegedly caused the Company's stock to trade at artificially inflated prices. Plaintiffs seek an unspecified amount of damages. The New York action has been transferred to Georgia and has been consolidated with the Georgia action, now styled In re: Ebix, Inc. Securities Litigation, Civil Action No. 1:11-CV-02400-RSW (N.D. Ga.). A Consolidated Amended Complaint ("CAC") was filed by Plaintiffs on November 28, 2011. On January 12, 2012, the Company filed a Motion to Dismiss the CAC, which raised various defenses that the CAC failed to state a claim. On September 28, 2012, the Court entered an order denying the Company's Motion to Dismiss. On December 7, 2012, Plaintiffs filed their Motion for Class Certification. On June 19, 2013, Defendants filed a Motion for Judgment on the Pleadings, which is presently pending. On July 2, 2013, the Court denied Plaintiffs' Motion for Class Certification without prejudice to Plaintiffs' refiling their Motion should the Court deny, in whole or in part, Defendants' Motion for Judgment on the Pleadings. On July 16, 2013, the Court entered a Stipulated Order Staying Discovery Pending Resolution of Defendants' Motion for Judgment on the Pleadings. In connection with this shareholder class action suit, there have been three derivative complaints brought by certain shareholders on behalf of the Company, which name certain of the Company's officers and its entire board of directors as Defendants. The first such derivative action was brought by an alleged shareholder named Paul Nauman styled Nauman v. Raina, et al., Civil Action File No. 2011-cv-205276 (Superior Court of Fulton County, Georgia). The second such derivative action was brought by an alleged shareholder named Gilbert Spagnola styled Spagnola v. Bhalla, et al., Civil action No. 1:13-CV-00062-RWS (N.D. Ga.), filed January 7, 2013. The third such derivative action was brought by an alleged shareholder named Hotel Trades Council and Hotel Association of New York City Pension Fund styled Hotel Trades Council and Hotel Association of New York City, Inc. Pension Fund v. Raina, et al., Civil Action No. 1:13-CV-00246-RWS (N.D. Ga.), filed January 23, 2013. These derivative actions are based on substantially the same factual allegations in the shareholder class action suit, but also variously claim breach of fiduciary duties, abuse of control, gross mismanagement, the wasting of corporate assets, negligence, unjust enrichment by the Company's directors, and violation of Section 14 of the Exchange Act. The Nauman case has been stayed pending the completion of expert discovery in the shareholder class action suit. On April 12, 2013, the Court entered an Order consolidating the Spagnola and Hotel derivative cases under the style In re Ebix, Inc. Derivative Litigation, File No. 1:13-CV-00062- RWS (N.D. Ga.), appointing Hotel Trades Council and Hotel Association of New York City, Inc. Pension Fund as Lead Derivative Plaintiff, and appointing the law firm Cohen Milstein Sellers & Toll PLLC as Lead Derivative Counsel and The Law Offices of David A. Bain LLC as Liaison Counsel. Lead Derivative Plaintiff filed its Consolidated Shareholder Derivative and Class Action Complaint on May 20, 2013. Thereafter, the Court entered a Consent Order on June 4, 2013, setting a schedule for Lead Derivative Plaintiff to amend its complaint in light of the anticipated preliminary proxy related to the transaction announced on May 1, 2013 with affiliates of Goldman Sachs & Co. Based on the termination of the merger agreement relating to that transaction, as announced on June 19, 2013, the parties are conferring regarding future case scheduling. The Company denies any liability and intends to defend the federal and derivative actions vigorously. The likelihood of an unfavorable outcome for this matter is not estimable.
On June 6, 2013, the Company was notified that the U.S Attorney for the Northern District of Georgia had opened an investigation into allegations of intentional misconduct that had been brought to its attention from the pending shareholder class action lawsuit against the Company's directors and officers, the media and other sources. The Company is cooperating with the U.S. Attorney's office.
Following the announcement on May 1, 2013 of the execution of a merger agreement with affiliates of Goldman Sachs & Co., eleven putative class action complaints challenging the proposed merger were filed in the Delaware Court of Chancery. These complaints name as defendants some combination of the Company, its directors, Goldman Sachs & Co and affiliated entities. On June 10, 2013, the eleven complaints were consolidated by the Delaware Court of Chancery under the caption In re Ebix, Inc. Stockholder Litigation, CA No. 8526-CS. On June 19, 2013, the Company announced that the merger agreement had been terminated pursuant to a Termination and Settlement Agreement. Defendants then moved to dismiss the consolidated proceeding. Lead Plaintiffs have indicated that they intend to amend their operative complaint and an order requiring them to do so on before August 20, 2013 was entered by the Court on July 24, 2013.
The Company has been sued by Microsoft in the N.D. GA for alleged copyright infringement, breach of contract, and unjust enrichment. Microsoft Corporation and Microsoft Licensing, GP v. Ebix, Inc., Case No. 1:13-CV-01655-CAP (N.D. Ga) filed May 15, 2013. The Company has not yet been able to determine exposure as the case concerns alleged underlicensing of Microsoft software and an audit is underway. The Company filed a motion to dismiss the case on July 10, 2013. On August 5, 2013, Plaintiffs filed their First Amended Complaint. The Company has and will continue to defend itself aggressively against Microsoft's claims.
The Company is involved in various other claims and legal actions arising in the ordinary course of business. In the opinion of management, the ultimate likely disposition of these matters will not have a material adverse effect on the Company's consolidated financial position, results of operations or liquidity.
There is no new hidden monster. The withdrawal of the Goldman offer was not because of a new legal spat with Microsoft; nor was it the discovery of a shortfall in internal controls revealed by Peak. Goldman lost its nerve because the shorts managed to escalate their charge of existing allegations into one of 'intentional misconduct.' The short selling was aided by skilful articles on Bloomberg that consistently claimed 'unnamed sources who requested anonymity due to the confidentiality of the matter'.
This makes an assessment much easier. Both the Copperfield and Gotham allegations have been systematically and comprehensively rebutted previously.
Copperfield Rebuttal: A fellow SA contributor, David Collins, posted a detailed note from a Craig Hallum analyst, Jeff Van Rhe: "Craig-Hallum Research Report Provides Counterpoint to Copperfield Claims". A less detailed explanation covering other points was written by me:"Critical Issues And Misinformation Surrounding Ebix"
Gotham Rebuttal: A great summary of Gotham's allegations and the rational explanation can be found here, posted by a fellow SA contributor, Spin. Longlivedassets-note16. It's perfect, illustrating why each of Gotham's allegations is groundless, a blow by blow explanation of Gotham's deficit in accounting re Singapore subsidiary and intangible assets.
In my opinion the Copperfield/Gotham articles deserve to remain anonymous, given the staggering lack of accounting expertise. Their skill may lie in intimating to the public the existence of non-public SEC probes, but I urge the author to attend a basic course in company consolidations before he puts a name to them.
As for Bloomberg's role, there have been a number of skilful articles, full of innuendos and unidentified sources to portray Ebix and its CEO in the vilest light. I dissected one posted on June 21 titled, "Ebix's Raina Loses his magic touch as US probes accounting", in my rebuttal here "Bloomberg's Campaign Against The Company And CEO". I demonstrated factual errors and the journalist's skill in misrepresenting reality.
Since the 2Q conference call, it's very clear that Bloomberg is clutching at all straws; the article above focused on the CEO's personal life and made various allegations about the Peak acquisition - we now know the Peak litigation is no longer even material, it's no longer even specifically disclosed as a legal issue!
But the Bloomberg journalist continued the allegations. On August 7 he developed a new angle: "Ebix Said To Be Reviewed By US For Money Laundering". Here again we have an undisclosed source:
"Federal investigators are reviewing Ebix Inc. 's cross-border financial transactions to see whether the Atlanta-based software company engaged in money laundering, according to three people with knowledge of the matter."
So who should you believe? A journalist at Bloomberg and his unnamed sources, or Ebix's management which have a legal and fiduciary duty (as well as a phalanx of recently appointed lawyers) to report such matters to their shareholders? That's a rhetorical question.
(One can only wonder what Bloomberg's next accusation will be. I can just see it: "Federal Investigators are reviewing Raina, the CEO of Ebix, to see whether he is nurturing and training children in his New Delhi orphanage to become terrorists, according to three people with knowledge of the matter.")
What is EBIX worth? The Valuation
The company has shown its mettle in difficult times. It's worth remembering that EBIX traded as high at $26 in 2011 before the onset of the first short article - that was when eps was 30% lower!
As staggering as it may seem, EBIX has been swamped by short sellers since 2011; the legal system has been skilfully manipulated to corner and short a smallcap share, the perpetrators adding to their fire via Bloomberg's campaign and their now famous, 'according to confidential people with intimate knowledge of the matter'. Granted there have been two undesirable SEC probes, but a detailed analysis of the short thesis reveals huge holes in the argument. Removing this thorn will transform the company's value.
Ebix has dramatically increased its legal counsel to deal with the situation. As stated by the CEO in the most recent CC:
"We continue to focus on our business. And I think we are absolutely very focused on dealing with all the legal issues. We are at a point where we absolutely realize that we have to take these issues head on. We think we have the best of attorney working with us on this, and at the same time, I think we believe that we have always run our business with integrity, transparency, and that will take us through all of this and in the meanwhile, as we focus on our business and build our momentum back again."
Once the class action suits are resolved and the shorts move on, the company's value will revert to its fundamentals:
A niche business with proven credentials in automating end-to-end insurance processing including an integrated CRM model to link into independent insurance agents. This is a growth business globally as insurers strive to lower costs via automation. Ebix's goal is to be the leading backend powerhouse of insurance transactions in the world, and its current product range covers Property & Casualty Insurance, Retirement Annuity Management, Health and Life Insurance. The Obama Care initiatives, in extending health coverage to lower income households, lends itself to Ebix's business.
Despite the recent negative publicity, Ebix's reputation remains intact. On August 14, Intel announced a parternership with Ebix, to bring user-friendly medical training programs using Intel's Ultrabooks to healthcare professionals be they doctors, nurses or sales reps. Investors might be disenchanted with the current legal imbroglio, but leading industry players are not!
Ebix is growing its global footprint - a new exchange solution was recently announced in Brazil. As further stated by the CEO in the recent CC, "We are in the process of negotiating a deal to deploy one of our exchanges in a western country wherein all brokers and underwriters across the region could be potentially using our solution, while Ebix could get paid a threshold recurring amount annually. This deal if clinched could have a very meaningful impact on our revenue streams."
Ebix provides enjoys a high degree (+80%) of recurring revenue; once an insurer has installed the Ebix system, the insurer becomes a captive client and Ebix's revenue will grow in tandem with the insurer's business.
As most of the proprietary programming is done in India, where the cost of a programmer is estimated to be a third of the US equivalent, Ebix can sustain operating margins around 40%. The Return on Capital, including goodwill, stood at 19.3% for 2012 and 22.5% for 2011.
Ebix has a successful history of bedding down acquisitions and extracting synergies. This has enabled a revenue growth rate of 24% in the last 3 years.
Quantifying The Valuation
In normalised times, Ebix can generate an organic revenue growth rate of 15%; throw in acquisitions, it can push the needle to 20-30%, as evidenced by the 24% rate in the last 3 years. Ebix has an excellent record of converting income into cash, with a normalised conversion rate of +100%. I would argue this deserves a Price/Cash multiple of at least 15, especially in light of the exceptional Return on Capital noted above.
In 2012 they generated $72m net cashflow from operations. Granted it will probably be less in 2013 after higher legal bills, but in time this will prove to be an exceptional year that terminated the concerted short effort.
Using a cashflow multiple of 15X on $72m cashflow gives a market cap of $1,080m or $28 per share. An investor would also benefit from the current dividend yield of 2.8%, an unlikely benefit for a growth share.
Management have been proactive during this crisis, and have authorised a $100m share buyback. I'm confident the coming quarters will see it exercised. Note at current prices, the $72m operating cashflow of 2012 could in theory purchase 18% of the entire outstanding share capital!
In addition, the current short ratio for Ebix (as of 31 July from Yahoo Finance) stands at 11.7m shares, or 39% of the free float! Any positive news is bound to lead to a massive short squeeze.
There are no direct listed peers for comparison with Ebix, it's a niche business spanning most insurance industry verticals. One could claim that it is the premier CRM module for life insurance, where an insurer integrates its tied and independent sales reps. From their website, "In use by many of the top 20 Fortune 500® Life companies and more than 100,000 professionals worldwide, Ebix SmartOffice CRM solutions are now considered the industry standard for agency management, practice management, and enterprise CRM." As a consequence, it's worth comparing Ebix's valuation with Salesforce.com (CRM), the leading CRM vendor (which admittedly covers all sectors, not just insurance).
Note that on a GAAP basis CRM is loss making, whereas Ebix had net margins of 35% for 2012.
It's also worth remembering that the deal terms of the $20 offer from Goldman showed the CEO would have increased his stake in the private company - this underscores the intrinsic potential.
Although one can empathise with management's aversion to remaining a public company after recent events, I hope they will reciprocate the loyalty most shareholders have shown and not bail into a Goldman-type agreement as soon as the skies have cleared. Ebix management, we stood firm through the storm, and now so should you.