Investools: Too Many Accounting Red Flags

According to Lee K. Barba, Chairman and CEO of Investools Inc. (SWIM), the "brokerage thinkorswim [TOS] and education metrics for November 2007 showed continued record trading activity and subscriber growth."

Shareholders in the investor education company applauded the report, with the stock hitting a new 52-week high intra-day of $17.77 a share. At the close of trading on Wednesday, the stock settled 2.91% higher than Tuesday’s close, up 49 cents a share.

In recent quarters, Investools has topped Wall Street’s expectations, and stockholders have been handsomely rewarded, with price gains of almost 70 percent in the past 7-months. To those loyal readers of the 10Q Detective, you know there is a "but" to follow. In some respects, Investools is no more than a glorified Seminar company (save for its online brokerage business)!

What is Investools?

Investools products and services are built around a proprietary 5-Step Investing Formula that is "designed to teach both experienced and beginning investors how to approach the stock selection process according to [its] proven investing formula."

A review of SEC filings suggests to us, however, that management never took the workshops or home study courses with the "proven investing formula." For the first six-months of FY 2007, the Company reported realized losses of about $4.0 million in marketable securities available for investment and subsequently sold!

Course offerings are generally combined with personalized instruction and ongoing support. They are offered in a variety of interactive learning formats, including instructor-led synchronous and asynchronous online courses, in-person workshops, and online coaching programs and telephone, live-chat and email support, which [supposedly] "solidify student understanding of the investing process and helps them take control of their financial futures."

Management boasts that the Company currently has more than 320,000 graduates and nearly 98,000 subscribers, "which indicates that the Investools Method is among the most widely adopted investor education system in the world."

Investools’ students can leverage the Company’s Investor Toolbox, consisting of "state-of-the-art proprietary investment tools, award-winning technology and analyst-quality data—the result of over 20 years of technical and user-interface refinements—to help with their investing."

Neither Investools or its employees, nor its independent contractors are licensed financial advisors. In fact, the premium fundamental and technical analytical software available at Investools can be had for FREE at a plethora of websites, from Morningstar to MSN Money's Stock Research Wizard.

"The Investor Toolbox takes the same institution-grade data and investing practices that commercial banks and investment firms use, and delivers them in a way that the average investor can easily leverage."

Investools Mentors

Investools brags that it "is the only investor education company that has more than 100 certified educators on staff to assist you." Funny thing--Investools is not an accredited educational institution. The 10Q Detective is left to ponder the definitive meaning of 'certified.'

In addition, of the seven mentor profiles to be found at Investools’ online homepage, only one has a history of employment with a Wall Street and/or Investment Banking concern—she was a stockbroker—and only three of the coaches had more than ten years of personal investing experience!

"Discipline weighs ounces. Regret weighs tons. Now is the operative word. The sooner you learn, the closer you are living your dream." ~ Workshop Instructor Eben Miller.

To all the bulls out there—tell me again how Investools is not a Seminar Selling company?

The Company ignored a request by the 10Q Detective for audited performance results for any of its coaches.

Accounting Red Flags

In November 2007, Investools restated its previously filed Form 10-Q for the 2Q:07 ended June 30, to reflect additional revenue recognition. The 10Q Detective believes that a material weakness still exists in Investools’ internal control over financial reporting.

For the Investor Education segment of Investools, which represents almost 69% of aggregate revenue, the Company recognizes revenue in accordance with the “Accounting for Revenue Arrangements with Multiple Deliverables” accounting principle: The Company often bundles (multiple deliverables) that include on-demand coaching services, website subscriptions, educational workshops, online courses, along with other products and services.

In our view, Investools is capable of determining many of these products/services being sold to—and received—by its customers. For example, the Investor Toolbox and Stocks Course offered online (for $199/month) and the Stock Workshop Seminar have clearly defined refund policies of 30 days and seven days, respectively.

• As separation of revenue sources is possible, we question the need for management to have deferred more than $135.9 million and $43.1 million on its books in current liabilities and long-term liabilities, respectively, of deferred revenue (as of June 30, 2007).

Hiding revenue as a deferred liability, even when the real risk of the customer trying to cancel the contract has lapsed, is advantageous during periods of slowing growth. By being too conservative in deferring recognized revenue during prosperous cycles, management can impact—smooth out—future reported revenue by accelerating the recognized product/service as being completed, boosting sales (when needed).

• Investools’ balance sheet is short on liquidity. At June 30, 2007, net working capital decreased by $39.4 million to $16.6 million, compared to $56.0 million at December 31, 2006, after excluding the change in the current portion of deferred revenue which is substantially a non-cash liability. The primary reason for the decrease in net working capital was the $45.0 million decrease in cash and marketable securities resulting from cash paid in conjunction with the merger with TOS (September 2006).

• A cursory look shows debt to be a manageable 25.3% of total assets. However, back out $207.2 million and $139.2 million of goodwill and intangible assets, respectively, and this coverage ratio climbs to approximately 89% of total assets!
• Although the Company’s debt levels may limit its ability to secure additional financing, payment of existing obligations should not be of material concern—given the Company remains profitable. For the three-months ended September 30, 2007, Investools could cover its interest payments five times over earnings (on a pre-tax basis).

However, in connection with the TOS merger, certain employees and consultants of TOS have the opportunity to participate in a retention bonus pool, which equals, in the aggregate, $20 million conditioned upon continued employment. The first payment is to be made in February 2008.The bonuses will be paid in equal annual installments over a three-year period.

In addition, come August 2012, a $37.5 million balloon payment on a term loan facility to JPMorgan Chase Bank , N.A. (JPM) is due.

Investment Risks & Considerations

1. Investools’ growth strategy for the educational segment of its business is dependent on the ability to sell existing training programs, products and services to new students, or to sell advanced training programs to current students.
2. Access to leads and customers is becoming more costly. Marketing costs are increasing, primarily due to increased spending related to Investools branded events, which are marketed via a television advertising campaign and online media. Of concern, this attempt to increase brand awareness and drive traffic to investools.com, is coming at a time when Investools is lowering prices of the marketed initial education courses (directed at increasing the number of graduates who could then be sold graduate-level products and ancillary subscription services).
3. Although active Investor Toolbox subscribers grew 15% (year-over-year) to 98,000, for the recently reported third-quarter ended September 30, sales transaction volume [STV] declined 16% to $47 million.
   
   [Ed. note. STV is a non-GAAP financial measure because it adds deferred revenue to recognized revenue to “assess the operating results and effectiveness of the Company and its reporting operating segments.” In other words, sales volume would have declined more precipitously had Investools reported only recognized revenue!]
4. The Company accesses more than 25% of its Investor Education sales transaction volume through co-marketing with Success Magazine. However, this sales channel is not exclusive, and Success may enter into identical or similar relationships with competitors, which could diminish the value of the relationship.
5. Economic, political and market conditions also impact discretionary consumer spending. Rising energy, additional credit market debacles, and/or falling stock prices could adversely impact the education segment’s unit transaction volumes, too.
6. Investools Method™, Investor Toolbox ™, and Turbosearch ™--Investools has numerous registered /trademarks, but the Company does not have any patents on its educational tools or trading-related technology. As such, in our view, this weakens the core competence, for it is possible that competitors could adopt technology or product or service names similar to Investools, thereby impeding the Company’s ability to trumpet its ‘proprietary’ technology and build brand identity, possibly leading to customer confusion.

Infomercial Scam?

Well, it's now been 2 years, and guess what, I am not the next INVESTools success story. Actually, I have lost nearly half of my savings trading the INVESTools method. I certainly never made my tuition back. I am now farther in debt than ever and my credit cards now exceed $50,000. The interest rates are so high that I can't keep up, and debt-collecting agencies are calling me, harassing me, and I am really in a serious financial state now. I can't say I owe it all to INVESTools, but I can honestly say about $30,000 of it has been lost going after the dreams that they sold me. ~ Rip Off Report 3/17/07

Rebuttal

There seems to be some misconception about Investools. First of all the few complaints to be found on the Internet are speaking from a perspective of a person(s) that were/are looking for a get rich quick scheme. Of course those things don't work and are scams. Investools is an educational system. Just as the books Warren Buffet suggest are educational tools. These tools are designed to teach Financial Knowledge. Never once was I told Investools would make me money. Simply they claim the system will teach you the principles of investing and teaches you the information that professional investors use to make their decisions. The point is you will still have to make your own decisions...you will still have to "play" the game of investing. This is tool, an educational system. It teaches a comprehensive course...it is not just a program that "tells you when to buy, what to buy, and when to sell." You will never find a true system for sale that does those things. ~ Chase. 8/10/07

The 10Q Detective believes that having tools that help you do industry group research, focusing your attention on the very best market sectors, and leveraging analytical software to make sure that a stock you are considering is in an up trending industry is worth the monies—especially for experienced or professional traders. However, Investools target market of novice traders would best be served by enrolling in an investment course offered at a local community college (for a fraction of the cost).

Valuation Analysis

Operating metrics—funded accounts, trading activity and active subscribers—are firing on all cylinders. Noteworthy is the potential dual revenue stream, converting Investor Education Group graduates to active trading accounts on the TOS brokerage business.

Volatility is good for transaction volume at TOS; however, on the negative side, a weak stock market performance, an ongoing credit crunch, and erosion in discretionary income could damage the Company’s retooled business model.

The online brokerage business is a bright spot in Investools’ portfolio. Recent metrics suggest that the Company has hungrily digested its September 2006 purchase of TOS.

For the third-quarter ended September 30, the brokerage division added 17,900 accounts to bring the total to 47,850. The company said investors wanted to take advantage of the wild swings in the market during the third quarter to make money trading.

Revenue from brokering investments more than doubled to $32 million.

The average commission rate increased, too. TOS charged a commission of $10.16 per trade, compared with $9.25 per trade in last year's third quarter.

Trading activity remains heavily options-oriented, with average annualized trades of 170 per account (compared to 11, 9, and 13 for AMTD clients, SCHW clients, and ETFC clients, respectively).

Approximately 31% of revenue now comes from online investing services; and, management expects this business to continue to account for an increasingly significant portion of revenues in the future.

As any student of stock markets ought to know, downturns or disruptions in the securities markets could reduce trade volumes and margin borrowing and increase the Company’s dependence on its more active customers—who receive lower pricing.

In addition, top-line visibility could be obscured by continued weakness at the Education segment—loss of pricing power and higher SG&A costs.

Sink or swim
Sink or swim
Whats it going to be when you dive on in

Enrollment expansion might be adversely impacted, too, by continuing allegations of dishonest sales practices and working capital issues.

Dive on in
Dive on in

Investool is trading at 18.4 times FY ’08 consensus estimates of 94 cents a share, a 6.9% premium to its peer group average of 17.2 times optionsXpress (OXPS), Ameritrade (AMTD), E*TRADE (ETFC), and Charles Schwab (SCHW). In our view, OptionsXpress Holdings Inc., an online brokerage specializing in options and futures, and discount brokerages are a consistent comparable for a valuation analysis—as TOS is the visible growth engine.

Whats it going to be when you dive on in
Everybody knows what Im talking about
Everybody knows what theyre hiding from

The technical indicators for Investools are bullish, as the stock broke out above its 10-week and 30-week moving averages back in August. And, management’s outlook for a positive fourth-quarter could generate additional upside for the stock price.

Hiding from
Hiding from

Nonetheless, despite Investools’ robust growth prospects, the 10Q Detective prefers to sit this one out, for the red flags we have painted for readers remind us of our own youthful days back in summer camp—when we were taught never to swim out beyond the flags.

Everybody knows what they’re hiding from
Waters fine from the edge
But how you gonna know if you dont get wet?

The red flags signaled to us that the water at Investools was too deep to swim without a flotation device. We prefer to stay on the beach.

Don't get wet
Don't get wet
How you gonna know if you don't get wet? ~ Australian folk band The Waifs
[Audio Clip. Sink or Swim]

Author David J. Phillips does not hold a financial interest in any stocks mentioned in this article. The 10Q Detective has a Full Disclosure Policy.

Comments

[Whartontown]

While I appreciate your stab at analysis, the bulk of it misses, by a wide margin, the efficiency of SWIM's business model. For argument's sake, lets stipulate that the bulk of your apprehension about the education side of the business might be valid (only marginally so IMHO). My own feeling is that when they lowered the cost for the toolbox to $199, they effectively amalgamated the otherwise publicly-available information and repackaged it into something with enough value to make it attractive for a novice with a zeal to learn. I would also add that I'm not at all sure that a recession will hurt this side more(as many otherwise un or under-employed people shift to personal investing and trading), but let's move on with the stipulation that the education biz isn't worth today's stock price.

What you both miss is that TOS has become one of, if not the best and most preeminent options-centric retail brokerage business' in the industry. They are BARRON'S #1 Options Software platform retail broker for 2007 and with the recent release of their new web-based systems, they might well take #1 in that spot as well in 2008. They've got the largest group of highly active options trading customers (many of them ex floor pros) in the business and their recent DARTS surpassed their competitor OXPS , all without having to severely discount their commissions. They have hockey-stick like growth in nearly every metric,,DARTS, NEW ACCTS, AUM,etc... (they break out fully funded accts, something many of their competitors still don't do!) and are growing at a pace, both mth-to-mth and y-to-y that is faster by multiples over the balance of other publicly held retail brokers. Another salient point is that TOS has the highest customer retention rate in the industry (they lose less than 2% of their accounts on a yearly basis), so they clearly are nurturing their customers and not just just churning commissions!!
Couple this very strong competitor in the retail brokerage community with the customer acquisition engine (even if it were to be a break-even or slight loss..WHICH IT IS NOT) of Investools, keep your overhead low (which TOS again is among industry leaders, and watch the efficiencies resonate for years to come. Additionally, TOS acquires a significant # of it own new accounts every month with acquisition costs 30% lower than OXPS, SCHW, ETFC, & AMTD. Recent market volatility, while hurting the likes of OXPS, AMTD, & ETFC DARTS, actually benefitted the bulk of the TOS customer base.

As I am away from my desk and don't have all my valuation #'s with me, I can't do a numerically specific equation for why this stock (just attributing the lion's share of the biz to the TOS side)is no less than fairly valued here, but suffice to say, Mr. Market, many others, and myself all can make that case. My point here is that you spend way too much, and short-sighted, time on the educational end of the business at the risk of ignoring one of the very best publicly-traded retail brokers.

[Chungst]

10Q Detective is committing the same mistake as the last critic (Paul Simenauer who, by his own admission, stated he was "dead wrong on SWIM"). Please advise the readers as to the intrinsic value of SWIM so we can discern how overvalued SWIM is. Mr. Simenauer had numerous opportunities to provide his intrinsic value analysis, and to date, he has failed to supply it. I hope 10Q Detective's response is better.

Second, how does 10Q Detective reconcile the positive cash free cash flow per FASB #95 based on the latest form 10-Q filing. I've stated before: "Cash flow from operations revealed $30.3MM in positive cash flow and investing activities consumed about $14.6MM for "capex-related activities" for a positive "free cash flow" of under $16MM for the nine-month period ended 9/30/07." Clearingly, if SWIM is engaging in "accounting gamesmanship" as hinted by 10Q Detective, how is SWIM generating positive free cash flow.

Third, and this is related to points #1 and #2, is comparing the SWIM model to either the Gillette model or HP model (i.e. lose on razor but make it up on the razor blades or lose on printers but make it up on ink, respectively). That is to say, the fundamentals at Investools itself is less of a concern than the profit engine and synergistic relationship when combined with thinkorswim. Or, I don't disagree with 10Q Detective views on Investools so long as the combined SWIM franchise makes money after the dust settles and the franchise is sound.

Lastly, 10Q Detective stated: "In fact, the premium fundamental and technical analytical software available at Investools can be had for FREE at a plethora of websites, from Morningstar to MSN Money's Stock Research Wizard." This statement wrong (and needs a retraction) -- for example, Investools clients have access to the Prophet software (please note I am a fundamental analyst by training), and I don't recall seeing Prophet's software at any of the sites mentioned by 10Q Detective.

Cheers.

[Soluskro]

"In some respects, Investools is no more than a glorified Seminar company (save for its online brokerage business)!"

This is where a reader might insert his own mental "but" as in: "but what I am about to read may have been pertinent if the article was written circa 2005".

Briefly, the Education side has been heavily discounted by analysts.
Back in May07, this is what MCF had to say:

"In our new estimates, we made deep cuts in the contribution
from the indirect marketing channels to assume no recovery during the rest of FY07 nor in FY08."

This is when the sum of the parts analysis (focusing on the brokerage side-- so in MOST respects, SWIM is now a brokerage business) called for $16-20.

BMO in August07 had this to say:
Accounting for the company’s education segment revenues and expenses creates confusion about that segment’s results and generates GAAP losses on the consolidated company’s income
statements. That is bound to create some impact on valuation, simply because the accounting is not as clean as some brokerage competitors. However, we believe the cash flow generation and
adjusted earnings are more representative of Investools’ true underlying performance, consequently our analysis and recommendation take those metrics into account as well; both are
likely to accelerate meaningfully over the next couple years and are the key drivers of our
OUTPERFORM rating."

Misunderstood. Hmm. MCF has recently updated their targets to $19-23, not just because of the explosive TOS side growth but because the educational side, which was already heavily discounted by most, has seen renewed growth under the new pricing strategy. Seems that reports of the death of the edu side for all of 2007 and 2008 was premature.

On the broker side, you should take a moment to do some metrics comparisons with some of SWIM's competitors and you will clearly see the reason for the premium.

Overall, I do think you get some things right and you do provide a balanced view on things like the complaints and rebuttal. I just think the focus of the article is incorrect with respect to where or why someone might invest in this company. The edu side is not the story. It's the brokerage side which merits an article.

Regards,
Ed

Full disclosure: I am not affiliated in anyway with Investools. I do have a LONG position since 2005 and I have used the toolbox since 2005.

[Whartontown]

BTW....I and others I am aware of tried to post rebuttals to this 10Q critique on the 10Q blog site, however, Mr. Phillips does not see fit to have any other opinions appear that might disagree with his. That suggests he has some undisclosed agenda or perhaps is working for others who do...very lame IMHO.

[10QDetective]

1. Variables: CAGR of 20%, sustainable operating margins of 25%, issuance of an additional 20M stock shares, equity risk premium of 3%, company beta of 1.05, and a WACC of 7.9%, intrinsic valuation of SWIM is about $28.00/share – big assumption is that company can continue to grow sales by at least 20% & sustain margins of 25 percent.

2. My apologies to all for the failure to timely respond to your comments directly on my blog. Unfortunately, I am under assault from spammers.