Ebix (EBIX) is a company that offers IT solutions, exchanges and back-office services to insurance companies. It is considered part of the cloud computing world which is so in vogue these days. It generated 46% top line growth and net margins of 44 percent. Yet the stock is heavily shorted and is down approximately 15% from $25 to $21 over the past few weeks, despite reporting good results for Q3-10.
So what is wrong with Ebix? Besides the fact that most of its equity is invested in goodwill, which is not unheard of for an acquisitive IT company, there is something else that keeps attracting the shorts.
I found one clue of what could be perceived as a future weakness in Ebix’s income statement; specifically, its effective corporate tax rate. According to Note 7 of the financial statement's10Q filing for Q3 2010, Ebix’s effective tax rate was 4.25 percent. The explanation for such a low rate is that it “reflects the tax benefits from having a higher mix of significant components of our operations outside the United States in foreign jurisdictions where earnings are taxed at rates lower than U.S. statutory rates."
However, reading the notes further we learn that the other jurisdictions that Ebix does business in are Australia, New Zealand, India and Singapore; not exactly tax havens. Then we find out that 75% of revenue is generated in the United States anyway. So, again, how can Ebix achieve such a low corporate tax rate? Should every corporation in the S&P 500 hire its tax advisors?
The answer appears to be further down in Note 7. As at September 30, 2010, the note says, the company had remaining available domestic net operating loss (NOL) carry forwards of approximately $28.5 million, which are available to offset future federal and certain state income taxes.
Ebix so far has enjoyed a tax shield carried over from prior unprofitable periods. This is a good thing. General Motors' (GM) terrific valuation included billions of dollars in carry forwards, which means that stock holders will not have to pay taxes on thousands upon thousand of cars sold by GM in the future. Not a bad deal if you think about it. (By the way, carry forwards are normally dissolved in bankruptcy court, not surprisingly, because the U.S. government wants to get paid its due once a company emerges from re-organization and starts generating profits.) GM was an exception since it was owned by the government, which meant investment bankers could throw orthodoxy out the window and make GM stock look really attractive with a shiny tax armor. In other words, Uncle Sam decided that one IPO dollar today was better than two tax dollars tomorrow. If you are the government you can make this type of determination.
Back to Ebix: The issue of having tax shields shouldn’t turn us away from the stock; however, it does have an impact on its valuation. So far Ebix has been reporting cash flow and earnings per share that are growing 30% faster than is sustainable by paying nearly nothing in taxes. As soon as the carry forwards are used up, performance will be negatively affected unless it finds a way to replenish the tax shield.
How long will it take for $28.5 million to run out? Not too long, considering Ebix reported net income of $43 million in the first nine months of 2010. One or two years would be my guess, depending on how fast it grows. Cash flows and earnings projections for Ebix should consider this as well as some potential dilution from convertible debt being turned into stock, some of which already occurred in Q3.
I listened to Ebix’s last conference call to see if I could get more information on its taxes. Mostly I liked what I heard from management. The Q&A portion of the conference call was succinct with low analyst coverage. However, one analyst did ask the question that I wanted management to answer, about the tax rate.
CEO Robin Raina responded with the "lower tax jurisdiction argument," which made it sound as if this was more of a permanent advantage -- which I found hard to believe. When the analyst pressed to know more about the carry forward, he did not get an answer. Personally I thought management could have been more forthcoming.
I was also surprised the CFO did not take any questions or even speak during the conference. The entire conference was the CEO’s one-man show. The call is available for replay and the transcript available at SA archive. In my view it would have been better if management had provided more clarity on its fiscal situation. This is a company that I want to root for, with great growth prospects, but I would like to get more clarity on the impact of its future tax rate.
Disclosure: Long EBIX with protection.
Disclosure: Long EBIX with protection.
Source: What's Wrong with Ebix?