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Introduction

A little over a year ago, I warned investors about Silicon Graphics (SGI), a company with little growth and no real earnings or cash flow that had somehow become a momentum stock by achieving a series of non-GAAP earnings "beats". The company delivered these "beats" by an extremely aggressive presentation of "non-GAAP" financial results that showed profits when the GAAP results showed losses and presented robust revenue growth when a careful analysis of bookings trends showed stagnation. Every quarter gullible sell-side analysts uncritically accepted management's non-GAAP spin and cheered them on, until finally the charade collapsed under its own weight. Fast forward to today, and SGI's stock is down by nearly two thirds from where I wrote it up and both the CEO and CFO have moved on.

At the time I discovered SGI I had never seen such an aggressive, and in my opinion misleading, presentation of non-GAAP results. Needless to say it was a great short, even better than I originally thought it could be. One lesson I took away from the experience was to be suspicious of non-GAAP results and be doubly suspicious of non-GAAP revenue adjustments. Well, I recently discovered a company that may well rival SGI in the all time non-GAAP hall of fame. As a short-seller's bonus, I think the downside in the stock could be even greater due to the high degree of financial leverage the company has assumed in the process of its growth by acquisition. That company is Web.com (WWWW).

Background

Web.com originally went public as Website Pros in 2005 as a purveyor of do-it-yourself ("DIY") and do-it-for-me ("DIFM") websites for small businesses. The company provides its services using internally developed technology and an on-shore sales call center and website development staff. Web.com has been very acquisitive over its history, first purchasing the Web.com business from which it takes its current name in 2007, then purchasing the domain name registrar Register.com for $135M in 2010 and finally purchasing Network Solutions in 2011 for $570M including the issuance of 18M shares at $9.16 per share. During the course of this acquisition spree, company accumulated a significant amount of debt, approximately $709M of gross debt (over 5x current run-rate adjusted EBITDA) as of its most recent 10-Q. Along with providing its traditional small business website development and hosting business and domain name registration, the company also provides small businesses with online marketing, email marketing and social media marketing services.

Better Company Than Google?

If you Google "small business website", "web domain registration" or "website hosting" you will get a plethora of hits, some from the Web.com brands and the rest from the gigantic number of competitors including Intuit, GoDaddy, Yahoo, Microsoft and many others. Many of these competitors spend heavily on marketing, which Web.com has bizarrely decided to counter by becoming the title sponsor of the PGA's qualifying tour. As you would imagine, they compete in a fairly commoditized market. On the Internet, unless you have a strong network effect like eBay, Google or OpenTable, competition tends to eat away margins. At this point, the market for small business websites has largely matured with little overall growth. It is difficult to get a read on Web.com's underlying growth given the myriad acquisitions, but from what I can tell reading their acquisition and pro forma revenue disclosures the company shrank in 2009 and 2010 on an organic basis, and grew very slightly in 2011. In Web.com's Q1 2012 10-Q filing, the pro forma revenue disclosure indicates revenue shrinkage on a GAAP basis. According to the acquisition disclosures both Register.com and Network Solutions pre-acquisition were flattish businesses that lost subscribers but made up for it by increasing ARPU over time.

I began doing work on WWWW because of its strong price appreciation. The various bullish sell-side analyst notes advanced the thesis that the combined company would be able to cross-sell its services, i.e. selling web domain name registrations to the traditional Web.com customers and selling Web.com website building and hosting services to the Register.com and Network Solutions installed base. In the first full quarter after the Network Solutions acquisition, the combined company did manage to add a small number of subscribers, the first quarter of organic subscriber growth since the first quarter of 2010. However, I was skeptical of the sell-side models that extrapolated this slight improvement into robust subscriber growth with constantly improving churn and growing ARPU far into the future. It also struck me as strange that analysts used metrics like 12x current EBITDA for their price targets, especially given that higher quality Web leaders with much faster organic growth and network effects like Google, eBay and OpenTable trade at lower multiples. I began to dig into WWWW's financials, and was surprised by what I found. After all, bullish sell-side analysts also claim that the stock is cheap on a P/E basis. Just what was in that "E"?

Losses into Profits

Much like SGI, WWWW's earnings press releases start with a significant GAAP accounting loss and contain numerous add-backs that magically bring the GAAP loss to a non-GAAP profit. WWWW's Q1 2012 earnings release contains no fewer than 10 add-backs. Some of these adjustments, such as adding back the amortization of intangibles, I had no problem with as they were non-cash items that should bring non-GAAP EPS closer to actual cash flow. Other adjustments, such as adding back repeated restructuring charges and corporate development expenses, seemed more questionable. However, I was struck by the sheer size of one of the adjustments: the "fair value adjustment to deferred revenue" which increased non-GAAP revenue, adjusted EBITDA and non-GAAP earnings by the same amount at 100% margin. As you can see in the table below, in 2010 this adjustment accounted for 71% of WWWW's non-GAAP earnings, 100% of non-GAAP earnings in 2011 and a whopping 161% of non-GAAP earnings in the first quarter of 2012. In other words, without this adjustment Web.com is actually losing money, even on a non-GAAP basis. What exactly is it?
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Source: Web.com press releases, author's calculations.

What is Non-GAAP Revenue?

From the table above, understanding the "fair value adjustment to deferred revenue" is key to understanding Web.com's financials and to ascertaining the validity of the supposed "non-GAAP" revenue and earnings. As it turns out, the fair value adjustment to deferred revenue results from the fact that at the time Web.com acquired both Register.com and Network Solutions, they inherited large deferred revenue liabilities that resulted from customers pre-paying multi-year subscriptions for domain name registrations. If Register.com and Network Solutions had remained independent, they would have recognized the revenue over time as the deferred revenue obligations were met, but obviously this would not involve collecting any new cash. Accounting rules stipulate that an acquirer write down the deferred revenue it acquires to "fair value" and reverse this write-down to deferred revenue over time as the liability is satisfied rather than recognizing the full amount of the deferred revenue as revenue. I believe that the rationale behind this accounting rule is that since the acquiring company is not actually collecting any cash associated with the deferred revenue (since the cash was presumably retained by the target's previous owners or on the balance sheet on the time of acquisition), the recognition of this deferred revenue is not actually revenue to the acquirer in any economic sense.

Web.com simply declares the fair value adjustment to deferred revenue to be "non-GAAP" revenue and adds it back to both revenue and earnings. This paints an unduly positive picture of earnings and EBITDA, which most analysts erroneously conflate with cash flow. Without this adjustment, Web.com is not profitable, and investors would be stuck with a no growth, no profits company that I believe would trade at a much lower enterprise value. In my mind, a proper non-GAAP adjustment takes a non-cash or truly one-time expense and adds it back to bring non-GAAP earnings per share closer to the actual ongoing operating cash flow. This particular adjustment does the opposite, taking a non-cash accounting adjustment and instructing investors to think of it as revenue and earnings. If you exclude this adjustment- which has nothing to do with the operating cash flow of the business- Web.com looks expensive on an EBITDA multiple basis, even looking out to 2013 when the fair value adjustment should be lower, and the cash flow to shareholders after interest and capital expenditures begins looks very anemic. My calculations are shown below in Table 2, where I refer to adjusted EBITDA less the fair value adjustment to deferred revenue as "New EBITDA".

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Sources: Thomson One for forward EBITDA estimates, a Wall St. analyst model for the 2012 and 2013 fair value adjustments to deferred revenue, Web.com's Q1 2012 10-Q for annualized interest and capex, author's own calculations.

Where is the Cash Flow?

Is this analysis fair to Web.com? After all, I believe it is misleading to add back non-cash deferred revenue adjustments at 100% margins and call it "non-GAAP revenue", "non-GAAP net income" and "adjusted EBITDA". But if these adjustments are indeed helpful to investors seeking to understand the underlying economics of the business, Web.com should show actual operating cash flow that roughly matches what it calls adjusted EBITDA less cash interest and taxes, and free cash flow that roughly matches its purported non-GAAP net income. In fact, due to the fact that Web.com runs a negative working capital business, where current liabilities are much greater than current assets, their actual cash flow should be better than earnings and EBITDA if the business has any growth. So to test my theory, I compared actual operating and free cash flow from Q1 of 2011 and 2012 and the last two full fiscal years to Web.com's purported non-GAAP net income. The results are in Table 3.

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Source: Web.com press releases and SEC filings, author's own calculations.

As you can see, during the time periods examined, actual free cash flow according to Web.com's financial statements fell well short of what the company reported as non-GAAP net income. In fact, in 2011 free cash flow was less than 1/3 of reported non-GAAP net income. This means that the fair value adjustments to deferred revenue and other non-GAAP adjustments are moving the company's non-GAAP earnings further away from cash and are not being fully offset by new deferred revenue collections. As I understand the accounting, of the $39.6M increase in deferred revenue shown in WWWW's Q1 2012 10-Q, $27.8M relates to the fair value adjustment to deferred revenue they are adding back to non-GAAP results at 100% margin and only $11.8M is actual new business deferred revenue cash collections. In my opinion, this also means that Web.com's non-GAAP revenue adjustments are painting a misleading picture of the actual free cash flow that is accruing to its equity holders. I noticed that while the gap between purported net income and free cash flow was enormous in 2011, it closed somewhat in the first quarter of 2012. I actually believe this was due to the fact that there are many subscription renewals in the first part of the year, and the gap between non-GAAP net income and actual free cash flow will grow wider again as 2012 goes on. Certainly, investors should pay very close attention to the Q2 cash flow statement to see if free cash flow continues to lag reported non-GAAP net income.

Not Exactly Recession Proof

Needless to say, none of the sell-side analysts has picked up on this glaring discrepancy between what Web.com says it earns and the cash it actually takes in. Even aside from the apparent lack of financial literacy, I am amazed at the cockeyed optimism displayed in Wall St. research notes about this company. I read a fair amount of dumb sell-side analyst commentary, but a recent analyst note promoting WWWW might be the dumbest thing I have read all year, and that is saying a lot. In this note an Internet sector analyst makes the contention that he has done a sensitivity analysis in a recessionary scenario and pronounced WWWW "SAFE & SOUND". Now keep in mind that WWWW primarily serves small businesses, which are much more sensitive to economic conditions than large companies or public institutions. During recessions, small businesses are less likely to purchase new services, fail at higher rates and are more likely to cut non-essential costs (such as a monthly subscription service that maintains your Facebook page for you). In a recession, you would expect Web.com's net customer adds to decline and ARPU to decrease, which is exactly what happened in 2008-2009. WWWW's stock was down by nearly 70% in 2008 and EBITDA declined significantly in 2009. Given that the bull story in WWWW revolves around sequentially improving subscriber adds, churn and ARPU as far as the eye can see, any reversals of these metrics (as you would expect in a recession) could be devastating for the stock. While Register.com and Network Solutions may be somewhat less economically sensitive than the original Web.com piece, the company also has something today that it did not have in 2008: significant financial leverage.

In a recession and accompanying bear market, small cap stocks get hit hard, stocks with small business exposure get hit hard and stocks of companies with significant financial leverage get hit hard. Stocks of small camp companies with small business exposure and financial leverage get slaughtered. Many leading economic prognosticators who correctly identified the previous recession in advance, including John Hussman, Lakshman Achuthan of the ECRI and even bond superstar Bill Gross believe the U.S. is either already in or entering a recession. If so, WWWW could be in serious trouble. Ominously for WWWW holders, the small business economy is already starting to show cracks. The National Federation of Independent Businesses reported a significant deterioration in small businesses optimism in their June report. Small business reluctance to spend may be just beginning.

Look Out for the Secondary

With an overvalued stock based on dubious non-GAAP, non-cash earnings and an over-leveraged balance sheet, I believe that WWWW wants to do a large stock offering to pay down debt and lower its risk going into what could be a recession. Additionally, the private equity firm that sold Network Solutions to Web.com still owns 8.5M shares after selling 7.6M shares at $15.25 during Q2. In fact, I suspect the private equity firm is eager to sell the rest of their stake given the higher stock price. So look for WWWW to have pulled out all the stops in order to put out a good Q2 report and file for a large secondary offering (including both the private equity shares and primary shares) immediately afterwards. I believe the relentless bullishness (11 out of 11 traditional sell-side brokerage analysts rate WWWW a "buy") and lack of critical analysis by the sell side largely stems from this significant potential piece of investment banking business.

Conclusion

If you believe it is appropriate to consider Web.com's fair value adjustment to deferred revenue as actual earnings and EBITDA, the stock's valuation seems reasonable. If you ignore management's spin and look at actual cash flow, the stock seems very expensive, and primed for a major decline. I believe that management has an incentive to paint a positive picture with its non-GAAP adjustments so that it can cash out a major investor and raise money at an attractive valuation to de-lever its balance sheet. Naturally, Web.com is abetted by gullible and lazy Wall St. analysts who are angling for a piece of the investment banking business. If the market took a harder look at Web.com's actual results instead of press releases, I believe the stock would be a lot lower, and if there is going to be a recession in the U.S. WWWW holders should run for the hills. In fact, if a recession did indeed cause Web.com's actual EBITDA and operating cash flow to stagnate or decline in 2013, its ability to meet the repayment schedule on its debt could be questionable. Either way, I do not think investors should stick around to find out.

Source: WWWW: The Case Of The Non-Cash Cash Flow