Analyzing Gradient Analytics (BVF, RACK)

Surely you've heard of Gradient Analytics by now, as it's all the Wall Street media outlets have been talking about lately. In case not though, let's recap. Gradient is a research firm based in Scottsdale, Arizona. They focus on forensic accounting analysis of public companies.

The latest issue that has been getting all the attention has to do with negative reports Gradient issued on Biovail Corp. (BVF), a poorly run Canadian drug company. Biovail is suing Gradient, claiming their inaccurate and misleading reports caused a 50 percent drop in BVF stock during 2003 and 2004. News broke that Steve Cohen, hedge fund manager at SAC Capital and Gradient customer, actually requested a report from Gradient that focused on negative aspects of Biovail' s business. SAC was interested in shorting Biovail shares, or perhaps they already were short at the time of request. Gradient did produce a report, and subsequently distributed it to the rest of its customers.

On the surface, this kind of thing looks very suspicious. If SAC Capital was short BVF and asked Gradient to write a negative report on it so they could profit from their short position, it certainly appears that so-called "independent" research is far from independent. Even still, a Gradient report is not responsible for a 50 percent drop in BVF stock, as the company contends. The company's financial results account for the drop.

In response to the lawsuit, Gradient has said that SAC was requesting a follow-up to a previous report it published about Biovail on its own. If that is true, and SAC was not ghost-writing these reports with false information (as some are contending), then it is hard to reach the conclusion that any law was broken. Unless Gradient and/or SAC knowingly dessiminated false information in order to profit from existing short positions, this issue seems to have been blown way out of proportion.

Most are screaming for disclosure of these types of relationships. As a result, Gradient should add some fine print at the end of its reports saying that they might have been published based on a client's request, not because it was the research firm's original idea. I have no problem with such disclosures, but don't think for a second that it will change anything.

Sell side research now discloses how many buy, sell, and hold ratings they have on all of their investment banking clients, but we still see mostly buy ratings on stocks of banking clients.

I recently read a report from a boutique firm specializing in healthcare stocks. They had a buy rating on the small cap biotech company I was reading about. In fact, at the end of the report they disclosed that their research analysts cover 11 companies with whom their firm has a banking relationship. All 11 stocks are rated "buy".

How much stock should investors put on Gradient's research anyway? Last week shares of Rackable Systems (Nasdaq: RACK) dropped 6 bucks temporarily after Gradient's computer model spit out a negative red flag about increasing inventories. They postulated this was a sign of poor earnings quality.

Unfortunately for Gradient's clients, the computer program wasn't able to research Rackable's business model. Had it done that it would have learned that Rackable, much like Dell Inc. (DELL), builds product only after it is ordered. So, all of its inventory has already been sold, thereby making increasing inventory levels a signal of stength in the business, not the opposite as Gradient concluded.

Comments

[Donn Vickrey:]

Chad,

With all due respect, you did not check your facts carefully before posting this blog. Clearly I cannot speak to the issue of the BVF lawsuit given the ongoing litigation. However, your comments regarding our research on RACK are incorrect and incomplete.

First, a team of analysts thoroughly researched RACK prior to issuing our opinion. It was not purely the result of a computer model as you allege. Second, we specifically addressed whether or not RACK was really a build to order model. In this context, a number of indicators cited in our report raised serious questions about the validity of this assertion.

I think that you should give our research a try. Our observations about RACK proved invaluable to clients upon announcement of Q2 earnings.

Respectfully,

Donn Vickrey
Co-Founder/Editor-in-C...
Gradient Analytics

2006 Jul 27 05:19 PM

[Chad Brand:]

Donn,

I merely wrote what was being reported by the financial media at the time and therfore relied on their reporting/research for my comments. If the RACK situation was misconstrued by them, and as a result, by me, I apologize.

That said, RACK has blown out consensus estimates in both quarters since my blog posting. In fact, despite the large sell-off today the company has actually guided 2006 sales and earnings above current estimates. I would argue that the drop in the stock price is due to multiple compression (it was trading at more than 60 times forward earnings when the stock was in the 50's) given that the company's projected financial results are actually higher now than they were several months ago.

Therefore, presuming that your red flag on rising inventories was pointing to weaker financial results in the future, and such results are the reason for the stock's fall, I think is very misguided. Remember, correlation does not always imply causation. Perhaps other issues (including valuation) were also mentioned by Gradient and could be behind the drop, but given I am not a customer of Gradient, I do not know if this was the case.

2006 Jul 28 10:37 AM

[Donn Vickrey:]

Chad,

Thank you for clarifying. I will just add one thing. It's not just the quantity of earnings that matters, it's also the quality. That a company meets or exceeds estimates, by itself, means nothing.

As for your multiple compression theory, what caused the market to suddenly compress RACK's multiple in the face of what you argue was good news (higher projected financial results)? Is the market that inefficient?

Best Regards,

Donn

2006 Jul 28 07:50 PM

[Chad Brand:]

Donn,

Interestingly, whether RACK met or exceeded estimates, by itself, meant EVERYTHING to the short-term, momentum traders who all bailed last night after the company guided down for Q3. The stock was down 33% within minutes. I doubt the people driving it lower were digging deep into earnings quality that quickly. Estimates were done being revised higher, the chart was broken, and as a result the shares are 40% cheaper 24 hours later.

The market is extremely inefficient in the short-run, due in large part to these types of traders. Was RACK worth 60 times earnings earlier this year? Did last night's earnings report warrant a 40% drop in the stock in a single day? Was the $6/10% drop within minutes an "efficient" response to news of Gradient's red flag of RACK earlier in the year? Indeed, I believe all three instances to be overeactions resulting from severe short-term market inefficiency.

Anyway, thanks for the dialogue and congrats to Gradient customers who were short RACK.

Take care,

Chad

2006 Jul 28 11:53 PM

[jolly singh:]

CHECK OUT form TRADING SO HIGH OOPS

2006 Jul 29 11:46 PM

[Donn Vickrey:]

Chad,

I still have to say that the multiple compression theory just doesn't hold. IMO, the business model isn't working and it was plain to see in the financials. The only downside is that we had RACK under examination again when the bad news broke this time.

Donn

2007 Jan 18 07:01 PM

[Donn Vickrey:]

That is, we had it under examination but they beat us to the punch.

DV

2007 Jan 18 07:01 PM

[Chad Brand:]

Donn,

It really is "all about valuation." The business model hasn't changed in the last several months, but the stock price doubled between earnings reports. Why? Because with $6-$7 in net cash and $1 in EPS, a stock price of $18 attracts value buyers. I suspect the same thing will happen again after another 40% haircut.

Chad

2007 Jan 18 08:30 PM

[Donn Vickrey:]

Regardless of your rationale, those who followed your advice lost money--pure and simple.

Donn

2007 Jan 30 06:19 PM

[Chad Brand:]

Donn,
Hate to tell you, but I have never recommended investors buy RACK shares, so nobody lost any money on such advice.

2007 Feb 01 02:14 PM

[sikako?:]

Time for Chad Brand to congratulate Donn Vickrey on the RACK call, and admit that at least in this case the market underreacted to the bad news in the financials.

2007 Sep 08 07:17 PM