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Below is Part II of our EBIX report. Please also see part one.

5) Potentially Illegal Tax Strategy and Impact on Earnings and Valuation

The most disturbing assumption we used in the ADAM accretion assumptions is the zero percent tax rate. EBIX has been a profitable company for 10 years and acquired another company that was profitable. Both companies generate a majority of their revenue in the United States (75% for EBIX and 100% for ADAM). How could it be possible that EBIX will not pay income taxes in the United States? In researching the topic, we found a disturbing explanation which, if changed, could dramatically alter the economics of EBIX's business, significantly impair its earnings expectations, and possibly subject the company to significant fines, penalties and back taxes.

Further, we believe aspects of EBIX's tax provision do not conform to GAAP and could result in a restatement (if the company had an auditor with the resources to scrutinize this accounting treatment). Since 2002, EBIX has provisioned $5 million in GAAP taxes in total, despite being profitable from a GAAP perspective each quarter. We find this discrepancy alarming. Below we highlight some prominent U.S. technology companies with meaningful international operations and their most recent tax rates.

Table 8 - Tax Rates

2009

2010

EBIX

3%

1%

salesforce.com

40%

41%

IBM (IBM)

26%

25%

Apple (AAPL)

32%

24%

Google (GOOG)

22%

21%

Microsoft (MSFT)

26%

25%

Source: company filings

EBIX utilizes two strategies to reduce their taxes. The first is the utilization of an NOL and a valuation allowance against their deferred tax asset. A valuation allowance against a deferred tax asset is used when a company is unprofitable and the deferred tax asset may not be used in the future. Until December 31, 2009, the company maintained a full valuation allowance against their deferred tax asset. This implied that they would never generate enough profits in the future to utilize the NOL.

This allowed the company to maintain a zero percent GAAP tax rate, as taxable income was reduced by the release of the valuation allowance. In its 2009 10-k, management justified the valuation allowance "due to uncertainties related to the potential adverse impact to our health benefits exchange operating segment associated with recently passed health care legislation."

For a company that had been profitable for 32 straight quarters with 35% "reported" operating margins for 13 straight quarters, this was an absurd argument. At December 31, 2010, EBIX maintained a $6.6 million valuation allowance (all tied to acquired businesses) after releasing $2.3 million in the fourth quarter 2010. We believe that the valuation allowance should have been reversed years ago and this accounting treatment suggests a lack of oversight from auditors and possible earnings manipulation.

The second strategy to reduce the tax obligation: EBIX utilizes a controversial transfer tax strategy to shift U.S. income to India and Singapore. Singapore represents just 3% of their revenue, 27 employees, and only $271,000 of fixed assets. The only meaningful asset is $135 million of goodwill and intangible assets (58% of total). In India, they generate no revenue, have only $3.1 million of fixed assets, and 530 employees (45% of total).

Table 9 - 2010 Geographic Mix

North America

Australia

New Zealand

India

Singapore

Total

Revenue

99,299

27,253

1,480

0

4,156

132,188

Fixed assets

3,646

688

40

3,161

271

7,806

Goodwill and intangible assets

98,190

545

0

0

134,993

233,728

Employees

533

77

12

530

27

1,179

Source: 2010 10-k

Despite generating 75% of revenue in the United States from mainly U.S.-domiciled companies, and minimal revenue from India and Singapore, EBIX has tried (successfully to date) to utilize a questionable loophole to reduce its tax obligation. Through a transfer tax mechanism, EBIX has shifted most of its U.S. income to its foreign operations. Through a series of transactions, EBIX transferred their "intellectual property ownership…into our Singapore and India subsidiaries." EBIX then utilizes foreign tax holidays to reduce tax obligations in these foreign operations. As table 10 suggests (from the company's 10-k), they have been successful in transferring most of their domestic revenue into foreign earnings.

Through this superficial series of transactions that pose no business purpose other than to avoid U.S. taxes, EBIX was able to generate a 140% operating margin in 2010 in its foreign operations. EBIX's foreign operation is the Rumpelstiltskin of finance, turning a $1 of revenue into $1.40 of profits. If the transactions are declared a sham, EBIX will face significant fines, penalties and back taxes. EBIX has generated almost $150 million of pretax earnings in the past five years. At a 35% tax rate, this could equate to over $51 million in back taxes prior to interest penalties or fines.

Table 10 - 10-k Income Disclosure

2007

2008

2009

2010

Domestic income before tax

12,823

7,921

14,501

13,694

Foreign income before tax

376

20,778

25,331

45,960

Total

13,199

28,699

39,832

59,654

North American revenue

31,474

48,340

73,431

99,299

Foreign revenue

11,367

26,412

24,254

32,889

Implied margin - Foreign

3%

79%

104%

140%

Source: 10-k

This aggressive tax treatment is similar to KPMG's tax shelter fraud scandal several years ago. The aggressive strategy pitched by the Big Four accounting firm resulted in a criminal conspiracy charge against KPMG and resulted in 19 indictments of criminal tax fraud, criminal conspiracy, and tax evasion. Another Big Four firm, E&Y helped EBIX concoct the current strategy. This is a strategy that any U.S. company could pursue if they had operations abroad and wanted to avoid paying taxes.

Given the precarious debt situation in the United States, the IRS and politicians are increasingly focused on companies like EBIX that enjoy all the benefits of the U.S.'s vast corporate wealth, stable regulatory environment and resources, but find loopholes to avoid or reduce taxes. This attitude was front and center in President Obama's State of the Union speech on January 25, 2011, where he said:

Over the years, a parade of lobbyists has rigged the tax code to benefit particular companies and industries. Those with accountants or lawyers to work the system can end up paying no taxes at all. But all the rest are hit with one of the highest corporate tax rates in the world. It makes no sense, and it has to change. So tonight, I'm asking Democrats and Republicans to simplify the system. Get rid of the loopholes. Level the playing field. And use the savings to lower the corporate tax rate for the first time in 25 years – without adding to our deficit.

The President might as well have been directing his comments to Robin Raina and EBIX. Following the President's comments, Republican Dave Camp, the Chairman of the House Ways and Means Committee, proposed cutting the corporate tax rate by "reducing or eliminating tax deductions and credits." A Democratic proposal aims to "end special tax breaks favoring certain business sectors and repeal a rule that allows companies to defer taxes on income earned abroad."

To this point, buried in its 10-k, EBIX disclosed that in the fourth quarter 2010 it took a "charge to increase the Company’s reserves for uncertain tax filing positions as evaluated by management." It appears that management may be acknowledging that its current tax situation is unsustainable.

Companies with low but unsustainable tax rates have historically traded at low multiples as the market adjusts their "E" in the price to earnings calculation. An example of this is Bermuda reinsurance companies, who trade at roughly 6x earnings under the assumption that their tax free status is unlikely to continue into perpetuity. EBIX recorded a 1.1% tax rate in 2010 and analysts appear to be modeling a 10% rate in 2011. A less favorable tax situation going forward dramatically changes the earnings profile, free cash flow and valuation of the company. Adjusting EBIX 2010 operating results for a 35% tax rate reduces earnings to $0.90 per share.

6) Free Cash Flow Myth

As a serial acquirer, EBIX free cash flow is not representative unless cash costs of acquisitions are included. EBIX needs acquisitions or the house of cards collapses. Roll-ups artificially increase free cash flow as they report significantly less cash research and development costs, which are recognized as an amortization expense and a cost of acquisition. In EBIX's case, this cash flow shows up in the cash flow of investing section of the income statement, not cash flow from operations.

If EBIX had to develop these products internally, this expense would come out of operating cash flow and significantly reduce free cash flow. This is one of the reasons EBIX only spends 10% of its revenues on R&D. EBIX's questionable tax strategy also distorts this figure. We estimate that EBIX's free cash flow was $33 million in 2010 at a 35% tax rate, implying over 60% downside to get to a more normalized low-teens multiple to free cash flow. We estimate its free cash flow was $25 million adjusted for a more normalized sales and R&D expense, implying over 70% downside.

Table 11 - EBIX 2010 Adjusted Cash Flow

CFO

52,779

Adjusted CFO for 35% tax rate

35,098

Capex

(1,754)

Adjusted FCF

33,344

Enterprise Value

1,244,781

FCF / EV multiple

37.3x

7) Significant Quality of Earnings Issues

EBIX appears to manage earnings through a number of various accounting tricks that reduces the quality of earnings. Over the past six quarters, the company's accounts receivables growth has exceeded its revenue growth by over 30% on average.

Table 12 - Accounts Receivable

9/30/09

12/31/09

3/31/10

6/30/10

9/30/10

12/31/10

Revenue growth - yoy

15.5%

55.4%

52.9%

43.6%

42.9%

12.1%

Gross A/R growth - yoy

30.4%

68.6%

63.5%

48.8%

54.4%

13.9%

Source: company filings

In the past, EBIX management has defended the problems with accounts receivable by focusing on aging. We would point out regardless of collection vintages, earnings appear to be managed through accounts receivables. As an example, in the third quarter of 2010, revenue increased only $1 million sequentially (despite the benefit of two new acquisitions and two that closed late in the second quarter). Accounts receivable increased over $4 million during that same period.

EBIX would have materially missed revenue and earnings estimates if it were not for this dramatic growth in accounts receivable and $3 million of net "cashless" revenue. Unsurprisingly, this data point received little scrutiny from the company's sell side analysts (who are all recommending the shares).

EBIX has experienced significant volatility in its allowance for doubtful accounts, another tool to distort the timing and quality of earnings. Despite the unrelenting growth in accounts receivable, EBIX has just recently started to increase its allowance.

click to enlarge

Another earnings quality issue with EBIX is the large amount of goodwill and intangibles that does not flow through the income statement. For most roll-ups, amortization of intangibles is one of the largest expense items on the income statement. In 2010, EBIX amortized less than $3.8 million of intangibles, or only 2.8% of revenue. EBIX allocates a significant percentage of its acquisition price to goodwill and indefinite-lived intangibles, which are not amortized.

About 90% of EBIX's goodwill and intangibles are classified as permanent. A shockingly low percentage is allocated to amortizable intangibles like customer relationships, developed technology, and trademarks. This is highly unusual for technology companies as advancements in technology make it nearly impossible to classify a contract, technology, trademark or customer relationship as indefinite (and able to contribute to cash flows into perpetuity), especially in highly competitive industries. This is highly suspicious and points again to a lack of oversight by the company's auditors with purchase price allocations and the desire to overstate earnings through lower amortization.

Table 14 - Intangible Assets

12/31/09

3/31/10

6/30/10

9/30/10

12/31/10

Indefinite-lived intangibles

29,223

29,293

29,299

30,238

30,552

Goodwill

157,245

160,455

164,993

178,459

180,602

Goodwill and intangibles - not amortized

186,468

189,748

194,292

208,697

211,154

% of total

90.1%

90.2%

90.2%

89.9%

90.3%

Intangible, net (amortized)

20,505

20,641

21,019

23,402

22,574

Source: company filings

In 2010, EBIX benefited from a number of low quality and unsustainable earnings drivers that will make earnings comparisons difficult. For example, a change in fair value of a put option granted to the aforementioned E-Z Data acquisition benefited earnings by $0.15 ($6 million on the cash flow statement on 12/31/2010). This benefit was only prominently highlighted in the third quarter 2010. Foreign exchange gains also added $1.9 million in 2010, or roughly $0.04 per share. We have no doubt that EBIX will detail one-time expenses in the future as they become an earnings headwind.

Please see Part III for additional research and our conclusion.

Disclosure: I am short EBIX.

Source: Ebix: Not a Chinese Fraud, But a House of Cards Nonetheless, Part II