In my first article on Acorn International (NYSE:ATV) I questioned whether the $30MM stock buy-back plan initiated December 4 was in fact in shareholders’ interest. I noted the proximity of this date to the end of the six-month lock-up period specified at the time of the IPO in May 2007. Since the company has not being doing well of late, the buy-back will provide support to the stock as insider’s shares continue to come on the market. I pointed out that shareholders’ effective leverage will be increased, which seems undesirable at a time when both the stock and earnings are under pressure. These are and were, to a large extent, questions about the value of the stock.
This article left open a larger issue, which I should now like to address. Does this questionable buy-back point to any particular issues of concern at the company, China’s largest TV direct marketer? This is a difficult question to answer, because information on the Shanghai company is scarce. I have had to confine myself to a detailed analysis of Acorn’s filings with the SEC during the period since its IPO. This approach does have the advantage of not going far beyond Acorn’s own statements and assumptions.
My answer is that there are a number of peculiarities in the company’s reports that may indicate a systemic problem. The amount of capital devoted by Acorn to unspecified short-term investments has increased throughout 2007. An increasing percentage of Acorn’s revenues over this period have come from these sources. These profits are correlated, quarter for quarter, with the appearance of equal amounts of deferred revenues (sometimes called “unearned revenues”) on the balance sheet, as if capital were wandering from there to the income statements. Without knowing the sources of these revenues, it is impossible to assess the risk profile of the stock. Clearly, accounts of the profitability, indeed the very nature of Acorn’s business need to be more carefully scrutinised.
Beginning in 2006 (quarterly balance sheets are not available before the May 2007 IPO), Acorn began devoting significant capital to “Short-term investments”, while such investments were negligible in 2005 and before. The current total of 38MM represents approximately 10% of the capital raised through the IPO. These increased levels of investment capital have been accompanied by growing amounts of “Other income” beginning in 2006 and growing throughout 2007. Acorn has stated on two occasions that this income stems from investments [Source: Acorn International Q307 Conference call, Form F-1 (IPO Prospectus)]. These revenues represent an increasing percentage of Acorn’s profits over the past nine months, accounting for more than 60% of the recent quarter’s earnings [Table 1].
Table 1: Correlation of short-term investment capital, other income, deferred (unearned) revenue liabilities, and earnings
If we ignore the contribution of “Other income” to profitability (as I shall argue we should in a moment), Acorn’s earnings for Q1-Q307 are halved: 0.34 a share vs. 0.63. Two thirds of these operational revenues were generated before the company was publicly traded. More worrisome, Acorn’s 2007 operational earnings are confined to a brief but intense period from Jan-June 2007, after which they fall off drastically. This pattern matches data available from Alexa on Acorn’s website usage, which one would expect to track response to Acorn’s TV advertising. What we see is a burst of earnings and web-visits around the IPO through to July, with both falling off rapidly afterwards. In October, visits to Acorn’s website drop back to 2006 levels, out of the bracket of sites that Alexa tracks. There is therefore some cause to fear that Acorn’s core business has eroded. As I mentioned in my earlier article, management admitted on the most recent conference call that it faces increasing competition in several of its key market segments. The pattern of web-site usage confirms this assessment, but it points to a further decline in sales as of October 2007.
There are, however, more serious concerns raised by the data in Table 1. Reporting of this investment income – if that is in fact what it is – is correlated, quarter by quarter, with a steady accrual of “Deferred revenues” (or, “unearned revenues”) on the liabilities side of the balance sheet. In the last two quarters, the correlation has been one-to-one. Once again, it is impossible to ascertain the exact nature of these deferred revenues. (A deferred revenue is a liability, since it records the fact that cash has been received for a service or good that has not yet been provided.) Since these liabilities exactly offset the gains due to other income, but appear on the balance sheet, it seems fair to say that most of Acorn’s income for 2007 (the Other income), will at some point be required to eliminate these deferred revenues. Thus it is better, for the time, being, to exclude these revenues from consideration of Acorn’s profitability, as I have done above.
According to Acorn’s statements so far, they derive significant income from short-term market activity. These activities correlate with the appearance of deferred revenues on the balance sheet. It is fair to ask whether those deferred revenues are in fact liabilities in the short-term investment portfolio? If they are, it would be desirable to quantify them, and to specify their sensitivity to market parameters. We cannot do this for lack of information; however, we may gain some idea of the nature of the investments by considering the following. Acorn declared 5.24MM of investment income in Q307, which derived from cash equivalents of 160MM and short-term investments of 38MM. Assuming a 3% return on the cash, the short-term investments must have generated 4MM on 38MM, an annual return of more than 50%. It is not possible to achieve these returns without substantial risk. If the deferred revenues are indeed reflective of future liabilities in these investment positions, then they may be highly market sensitive.
In short, Acorn’s core business appears to be eroding, while ever more of its earnings derive from unspecified, but apparently risky market activities. The market exposure of the company, which may at present be considered an investment company, is impossible to quantify. When one combines these results with my earlier arguments concerning the recent buy-back plan, a disturbing picture emerges. Acorn cannot buy its shares back with earnings, since these are increasingly scarce (unless investment returns increase still further). So it must borrow to do so. The buy-back plan does not stipulate that shares be bought back in the open market. The company could apparently elect to buy back shares directly from insiders using borrowed capital. Since the operations of the company may well already include leveraged security positions, the effect of the buyback is to leverage these positions still further. Meanwhile real earnings – those derived from the marketing and sale of consumer products – are plummeting. There is reason to believe that the core business is not the business it once was.
It remains possible that the increase in unearned revenues only accidentally correlates with other income, and that the latter income is derived from conservative investment strategies. But whether or not the correlation is accidental, it is there. Half of FY07 earnings will effectively be garnisheed to cover future, perhaps volatile liabilities. And the high returns Acorn earns on its investments are not consistent with low-risk portfolio strategies. If there is a working business here, it will have its fair price – but that will be quite different from the market’s current assessment, and it cannot be settled until the exact nature of Acorn’s short-term investment activities is known.
Disclosure: The author is short ATV