I believe investors should be extremely cautious about Elephant Talk (ETAK) shares and give a SELL recommendation at the current price of $0.86 with a price target of $0.20 if it can avoid bankruptcy as its cash burns rapidly.
Current active law enforcement investigation
According to a Freedom of Information Act (FOIA) request with the SEC there is an ongoing law enforcement investigation into Elephant Talk.
The FOIA can be accessed here.
Specifically, the FOIA reads:
We are withholding records responsive to your request under 5 U.S.C. 552(b)(7)(NYSE:A), 17 CFR 200.80(b)(7)(NYSE:I). This exemption protects from disclosure records compiled for law enforcement purposes, the release of which could reasonably be expected to interfere with enforcement activities.
This means, beyond any doubt, that Elephant Talk is the subject of a current law enforcement investigation.
There has been some confusion among investors about what a 7 FOIA exemption means so I will explain the significance of this language below.
Quoting directly from the Department of Justice Guide to the Freedom of Information Act:
The first subpart of Exemption 7 of the Freedom of Information Act, Exemption 7,
authorizes the withholding of
"records or information compiled for law enforcement purposes, but only to the extent that production of such law enforcement records or information . . . could reasonably be expected to interfere with enforcement proceedings."
The 7 exemption is standard across FOIAs from all branches of the US government, including both the Department of Justice and the SEC.
A FOIA request to the SEC returning a 7 exemption is exceedingly rare and indicates a law enforcement investigation into the company is under way. Based on numerous discussions with the SEC, I know for a fact that:
1) A 7 exemption absolutely means a current law enforcement investigation is under way and there is no other possible interpretation for this FOIA response
2) The representative I spoke with estimated <1% of all US public companies return 7 exemptions - this exemption is absolutely not present for the majority of US public companies
By way of counter example, I have also included two negative FOIA responses that each indicate the lack of 7 exemption, and therefore lack of a current law enforcement investigation:
The first company, Centrix Bank & Trust (OTCQB:CXBT), has no 7 exemption. This company is not currently under a law enforcement investigation and has no material records of an investigation taking place.
The vast majority of US public companies have FOIA responses identical to Centrix and iCad because the majority of companies are not under investigation. This is the only possible interpretation for these FOIA responses. Elephant Talk is under a current law enforcement investigation.
I have no position in either CXBT or ICAD and these companies are not related to the rest of the content in this report.
Two Credible Directors Resign voicing concerns over board independence
At the Dec 18, 2013 shareholder meeting, two credible directors - one the retired Chief Sales and Marketing Officer at Sprint PCS and the other a 30 year veteran of HSBC - and both members of the audit committee at the time - resigned in a rare vocal resignation related to disagreements with the company. More bizarrely the resignations appear to be coerced, as QAT Investments (the largest shareholder where ETAK's CEO is also its Chairman) voted against these 2 independent directors. Was the CEO kicking off the truly independent board members so the fox could guard the henhouse?
From the resignation letters to the company on that date:
I hereby resign as a director of Elephant Talk as a result of differences between Management and certain minority shareholders and myself regarding the roles and responsibilities of the independent directors. …I hope that the new Board members will effectively represent the shareholders and perform the duties required of independent board members
This is particularly notable given that it appears that the CEO has been participating in related party financing transactions that appear to have been at least partially the source of the internal control issues via the improper warrant accounting and associated restatement [AE1] for the June 30 2013 10-Q. Further - these two coerced resignations left the company out of compliance in December 2013 with the NYSE as they no longer had a majority of independent directors.
Reputable auditor BDO is replaced by tiny Squar Milner after repeated internal control failures
On March 26, 2014, BDO USA, LLP ("BDO") informed Elephant Talk Communications Corp. (the "Company") that it declined to stand for re-appointment as the Company's independent registered public accounting firm in connection with the Company's audit for the fiscal year ending December 31, 2014.
As disclosed in Item 9A of the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2013, the Company concluded that material weaknesses existed in the Company's internal control over financial reporting.
ETAK has failed to maintain effective internal controls for multiple audits under BDO:
From the 2013 10-K:
In our opinion, Elephant Talk Communications Corp. did not maintain, in all material respects, effective internal control over financial reporting as of December 31, 2013, based on the COSO criteria.
From the 2011 10-K:
In our opinion, Elephant Talk Communications Corporation did not maintain, in all material respects, effective internal control over financial reporting as of December 31, 2011, based on the COSO criteria.…These material weaknesses, if not remediated, create an increased risk of misstatement of the Company's financial results, which, if material, may require future restatement thereof….
The June 2013 10-Q needed to be restated after internal control issues.
Additionally BDO gave ETAK a "going concern warning" in the March 2014 filed 10-K:
the Company has suffered recurring losses from operations, has an accumulated deficit of $225.4 million and continues to generate negative cash flows. These factors, among others discussed in Note 2, raise substantial doubt about its ability to continue as a going concern.
ETAK announced April 1, 2014 that it switched to using the services of Squar Milner, ranked only 70th out of the top 100 auditors, which is tiny for a public company with the complex accounting and needs of an international organization like ETAK.
Restating Financials and Related Party Transactions
For the Quarter ended June 30, 2013, ETAK had to restate its financials, increasing its warrant liabilities from $2,428,919 as originally filed, to $5,291,351 as restated.
Why Does ETAK need to borrow money from insiders and then repay then at 110% of par - creating a $1,938,597 extinguishing their debt?
Why did ETAK make a loan to insiders and then terminate that loan 2 months later?
Were these transactions why the independent directors resigned and why BDO was unwilling to continue as ETAK's auditor?
From the 10Q:
Note 14. 8% Senior Secured Convertible Note
On June 11, 2013, Elephant Talk Communications Corp. entered into a Purchase Agreement with each holder of the Company's Senior Secured Convertible Notes issued on March 29, 2012 pursuant to which the Company purchased the Convertible Notes at the purchase price equal to 110% of the aggregate of the outstanding principal amount of the Convertible Notes and interest due. The aggregate purchase price paid to the holders of the Convertible Notes was $6,701,824 which was paid out from the proceeds of the Share Purchase Agreements described under Note 15.
The Purchase Agreement with the note holders resulted in the regular and accelerated amortization expenses during the second quarter of $349,639 for the (OID) original issue discount, $1,179,732 for the (CF) conversion feature and $310,995 for the remaining financing costs of the note. The release of the balance of the fair market value of the conversion feature resulted in a gain of $451,779. Furthermore the 10% prepayment fee of $607,538 on the purchase price compared to the net outstanding principal was recorded as a loss in the income statement as part of the Loss of Extinguishment of Debt. The total Loss on Extinguishment of Debt was calculated at an amount of $1,938,597.
Note 15. 12% Unsecured Loan from Affiliate
On May 24, 2013, the Company entered into a certain loan agreement with a member of its board of directors pursuant to which the Company borrowed a principal amount of €1,000,000 ($1,290,790) for a period of one year at the interest rate of 12% per annum ("Loan Agreement") and issued a warrant ("Warrant") to the director to purchase 1,253,194 restricted shares of Common Stock exercisable at $1.03 per share for a term of 5 years, with a mandatory cash exercise after 12 months in case the average closing bid price is $1.55 or higher for 10 consecutive trading days.
Following ASC 470-20 guidance the Company allocated the fair market value, using the binomial valuation method, of the detachable warrants between equity and debt and accounted for the debt component separately, with the debt discount off set against paid-in capital. The debt discount being the initial fair market value of the warrants amounted to $434,433 and will be amortized using the effective interest method during the life of the loan.
Subsequent to the above, the Company entered into an amendment on July 14, 2013 to terminate the Loan Agreement, which is more fully described under Note 25 (subsequent events).
Conclusion: NYSE Delisting now at final allowable extension
It appears to me that there Elephant Talk has a lot of explaining to do to its shareholders. What is this current law enforcement investigation about? Why did the independent directors truly resign after apparently being voted against by other insiders, voicing their concerns over board independence?
Will ETAK be delisted on or before November 17th - the final deadline from the NYSE?
Does the NYSE know about the current law enforcement investigation? I wouldn't be surprised to see ETAK delisted before the deadline.
From their May 15, 2014 PR:
The Company initially received notice from the Exchange on May 17, 2013 indicating that the Company does not satisfy the continued listing standards of the Exchange set forth in Section 1003(iv) of the Company Guide in that the Company has sustained losses which are so substantial in relation to its overall operations or its existing financial resources, or its financial condition has become so impaired that it appears questionable, in the opinion of the Exchange, as to whether the Company will be able to continue operations and/or meet its obligations as they mature. The Company was afforded an opportunity to submit its initial plan of compliance to the Exchange, and, on May 31, 2013, the Company presented its Plan to the Exchange. On June 13, 2013, the Exchange accepted the Plan and granted the Company an extension until August 31, 2013 along with subsequent extensions to November 30, 2013, January 31, 2014 and April 30, 2014.
Making Money is Harder than Stock Promoting
Management is aggressively promoting ETAK stock by attending 8 conferences in the last 12 months and apparently paying third parties to promote their stock in newsletters. A software company in startup mode requires intense focus and I don't believe it is possible be successful in a highly competitive market while spending this much time traveling and pitching investors.
Since 2008, ETAK's revenues have declined by half from $44mm to $22mm in 2013 while share count has increased roughly 5 TIMES! Cumulative net losses have almost equaled revenue during this period: $196mm of Net LOSSES in 2008-2013 vs. $209mm of cumulative revenues.
(This chart is created by me using data directly from SEC filings)
However, I believe these conferences and stock promotions are a key element of ETAK's ability to collect warrant exercise proceeds as part of the director-related financings ETAK has pursued to fund continuing net losses.
In the future, the warrant overhang will ensure an increasing supply of shares in the event that the stock price increases! From the most recent 10Q:
in the event that the common stock trades at a price that is 20% or more above the exercise price of the RD Warrants for a period of twenty consecutive trading days…, the Company may require the holder of the RD Warrants to exercise. This would likely result in substantial further dilution.
ETAK has had significant employee turnover in key roles
In its May, 2014 investor presentation, ETAK highlights its "strong growth outlook for 2014 and beyond." Of course this growth will depend on the team ETAK already has in place at the company.
In the 2013 10-K, ETAK discloses that it has 195 employees. I checked LinkedIn and was able to find data on approximately 60% of these employees. Some level of turnover is normal at any company, but I was surprised to see significant turnover among what appear to be key employees at the company. Note that this is just a sample of the total employee turnover.
Specifically, the following people have departed in roughly the last two years or less:
· Chief Commercial Officer (Elephant Talk): Departed March 2012
· Vice President Worldwide Sales (ValidSoft) / Sales Manager Europe (Elephant Talk): Departed December 2012
· Global Head of Marketing (ValidSoft): Departed April 2014
· Managing Director, Asia Pacific (ValidSoft): Departed May 2012
· Sales Manager, Northern Europe (ValidSoft): Departed April 2013
· Sales Manager, Netherlands Elephant Talk): Departed July 2013
· Senior Software Architect (Elephant Talk): Departed February 2014
· Financial Reporting (SEC) Controller (Elephant Talk): Departed May 2013
Why is it that so many senior sales and marketing people have recently left the company? Of course ETAK can hire new people, but it takes significant time to ramp new sales people.
How much of ETAK's consistent revenue decline over the last 3+ years is related to these seemingly key employees leaving the company?
(Both charts above created by me using SEC filed data)
All in, it is hard for me to have confidence with this turnover and historical revenue decline that ETAK has a "strong growth outlook for 2014 and beyond"
What is ETAK worth?
In trying to determine a fair value for ETAK, I reviewed public comparables and transaction comparables data from CapIQ. PhoneFactor was listed as a comparable in ETAK's 2012 10-K.
According to data obtained on CapIQ, at the time of acquisition, PhoneFactor had LTM revenue of $72m, LTM EBITDA of $29m, and LTM net income of ~$16m. The transaction price was $250m market cap and $196 EV. The company had total assets of $122m and total equity of $69m, both substantially in excess of ETAK. This valued PhoneFactor at 2.7x EV/Sales, 6.75x EBITDA, and 15.6x P/E. This seems to be more than a generous comparable because unlike ETAK, PhoneFactor was significantly profitable, and had 3x the revenue base (bigger is generally better for acquisition multiples).
Using this valuation, ETAK might be worth ~$0.38 in a similar transaction in an extremely bullish scenario (based on the financials, ETAK is a lower quality money-losing asset than PhoneFactor profits).
The math for this is $23m LTM revenue for ETAK times 2.7x = $62m less $7m of net debt = $55m of market cap, divided by ETAK's 146.7m fully diluted shares outstanding. This is a value of $0.38 per share.
This is probably too optimistic. For starters, ETAK has lost a tremendous amount of money over time, is facing NYSE delisting, has internal control issues, a current law enforcement investigation, and a cloud hanging over the stock due to a noisy director resignation and employee turnover in key roles. All of these issues would put ETAK at a disadvantage during a transaction negotiation.
Further, it seems telling in and of itself that Microsoft decided to purchase PhoneFactor instead of Elephant Talk. Surely even the most bullish ETAK shareholder can concede that the good people of Microsoft's M&A department have a good idea what they are doing. Apparently the smart money preferred the PhoneFactor asset to ETAK.
What about public comparables?
The only relatively comparable public company I could find was Amdocs (NYSE:DOX), which sells for 2.2x EV. Unlike ETAK, DOX has grown its revenue substantially over time, reduced its share count, and is highly profitable with EBITDA margins in the upper teens or low 20s.
At 2.2x EV/Sales, ETAK would be valued at $0.30. This is also probably too optimistic.
In reality, ETAK would likely still sell for a discount in the stock market relative to a much larger, more liquid public comparable with far fewer issues. In my opinion, a fair public markets fair value for ETAK would be in the $0.15-0.20 range, assuming the company can avoid bankruptcy and delisting, and assuming no adverse outcome in the current law enforcement investigation. This means ETAK has at least 75% downside from the current price if it remains a public company, assuming it does not go bankrupt.
I contacted management numerous times and was not able to reach anyone over the phone to answer my questions.
Disclosure: I am/we are short ETAK.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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