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Copperfield Research is the pseudonym of a research team focusing on publicly traded equities. As of the publication date of our articles, we may have long or short equity positions in the companies covered. We do not discuss unpublished reports, or provide any advanced warning of future reports... More
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  • Avid Technology, Inc. (AVID): Ugly Financials With Loads Of Deception

    Today, we shared our opinion and research on AVID. Below is a synopsis of the topics covered in our full report, which can be found here:

    Our AVID Opinion: A turnaround stock promote that is really a money-losing melting ice cube masked by misleading revenue amortization and disingenuous communication. Transient factors have further contributed to a stock price completely detached from deteriorating underlying fundamentals.

    Fair Value: $5.53 per share, 69% downside


    IMPORTANT Disclaimer - Please read this Disclaimer in its entirety before continuing to read our research opinion. You should do your own research and due diligence before making any investment decision with respect to securities covered herein. We strive to present information accurately and cite the sources and analysis that help form our opinion. As of the date this opinion is posted, the author of this report has a short position in the company covered herein and stands to realize gains in the event that the price of the stock declines. The author does not provide any advanced warning of future reports to others. Following publication of this report, the author may transact in the securities of the company, and may be long, short, or neutral at any time hereafter regardless of our initial opinion. To the best of our ability and belief, all information contained herein is accurate and reliable, and has been obtained from public sources we believe to be accurate and reliable. However, such information is presented "as is," without warranty of any kind - whether express or implied. The author of this report makes no representations, express or implied, as to the timeliness or completeness of any such information or with regard to the results to be obtained from its use. All expressions of opinion are subject to change without notice and the author does not undertake to update or supplement this report or any of the information contained herein. This is not an offer to buy any security, nor shall any security be offered or sold to any person, in any jurisdiction in which such offer would be unlawful under the securities laws of such jurisdiction.


    Wall Street loves turnaround stories. Unfortunately, for every seemingly broken business that miraculously recovers, there are many more failed turnarounds that result in significant investor losses. We believe after a lengthy period of delinquent financials, Avid Technology (OTCPK:AVID) has re-emerged as a disingenuously promoted turnaround. The promotional story, combined with an unusual Russell 2000 anomaly that has required net indexers to buy approximately 3.4 million shares over the last few months,[i] has resulted in a parabolic stock advance.

    Digging into the AVID details reveals a highly misleading story, replete with promotional investor videos and presentations, pro-forma financials that fail to reflect the actual economics of the business - while in several cases failing to reconcile with SEC filings, and what we believe to be foreign exchange speculation that has added materially to financial results, yet has not been shared by management in earnings releases or conference calls. AVID's "adjusted results" are inaccurate representations of its actual underlying economic profile, distorted by management's inclusion of non-cash remnants of its accounting restatement. We believe substantial evidence exists that AVID has violated the spirit, if not the letter, of SEC Regulation G with regard to its seemingly abusive adjusted financial reporting. Further, our work suggests AVID's current turnaround team may not have had the successful exit from their previous company, Open Solutions, as many believe. We are also troubled that AVID's perceived turnaround specialist was previously sued by former employees who accused him of withholding financial information and violating his duties to care for shareholders.[ii]

    For nearly a decade, AVID has struggled to generate growth, while producing minimal economic profitability. Years ago, AVID dominated the market for converting video from tape to digital. However, AVID's relevance faded in the editing market, which is now populated by industry heavyweights such as Adobe, Apple, and Sony. It is no surprise that AVID's market share has shrunk to just 7% - 8%,[iii] rendering its business subscale as evidenced by economic EPS losses of ($1.03) and ($0.28) in 2014 and 1Q'15, respectively (excluding amortization of pre-2011 deferred revenue). Nonetheless, the AVID melting ice cube has resurfaced, thanks ironically to a massive accounting restatement that optically changed AVID's GAAP reporting.

    The juice in the AVID story has emanated from the perception that financial results have been "improving." The reality is AVID's results have been artificially overstated by the recognition of $888 million of deferred revenue "created" retrospectively to the actual 2010 ending balance. The massive accounting restatement has allowed AVID to flow 100% margin revenue through its income statement, resulting in an egregious overstatement of revenue, EBITDA, and EPS. We believe management's illogical inclusion of this misleading accounting artifact in its adjusted financial results has led to a severe misrepresentation of its underlying business. We believe these accounting details are indiscernible for quant buyers and/or unsuspecting retail investors that rely on investment screens. Institutional investors and sell-side analysts are presumably aware of the nominal restatement benefits; however we are convinced the actual nuances of the revenue amortization are not understood. Herein, we meticulously detail why the actual economics of AVID's transactions should mean that effectively zero of the pre-2011 revenue would still exist today under current accounting rules. As we carefully illustrate, the restatement impacted only a single-digit percentage of AVID's pre-2011 transaction value, yet many multiples of the affected revenue have essentially been double booked at a 100% margin based on nuanced accounting changes. The thesis that the water coming into the bathtub (new deferred revenue) will eventually offset the water that has been leaving the bathtub (pre-2011 deferred revenue amortization) is simply wrong.

    We believe investors and analysts have not only been fooled into assigning a hefty multiple, and hence value, to the pre-2011 deferred revenue amortization, but have also been hoodwinked by material non-recurring benefits not appropriately disclosed by management. We believe management took credit for recurring cost initiatives that appear to have been the result of FX hedging transactions and/or gains. AVID has inexplicably chosen to AVOID accounting for its hedges under hedge accounting, which has resulted in substantial FX transaction gains quietly flowing through the sales and marketing line. Further, we believe ample evidence exists that reported metrics have been "massaged" to fit the bullish turnaround rhetoric. We find these tactics to be in gross violation of investor trust and possibly of SEC regulations. Considering insiders were transacting in the stock less than 3 business days prior to the public announcement of a convertible debt offering, we would not expect the Board to act on behalf of shareholders with a proper investigation. Nonetheless, we believe the recent convert offering speaks volumes about how AVID's management views its equity valuation, while rendering a sale unlikely. This report provides detailed analysis examining the following concerns:

    I. Background & Accounting Restatement:

    · AVID has been a melting ice cube for nearly a decade. Prior to the overnight creation of $888 million of accounting-related deferred revenues, AVID had multiple failed growth attempts, including two entries and divestitures into the consumer space. We calculate AVID's organic revenue contracted by 3.9% annually from 2006 - 2010, which now looks like the glory days of growth.

    · In 2013, AVID was required to restate financials going back to 2005 because it had failed to identify and account for post-transaction deliverables, such as updates and bug fixes on a large number of transactions. Accounting rules required some portion of the transaction value to be deferred to account for such future deliverables. This had a particularly big impact on pre-2011 years when AVID had not yet adopted the FASB Accounting Standards Update No. 2009-13 and 2009-14 and was unable to estimate the value of such post-transaction deliverables. In the absence of an objective estimate of that small portion of the transaction, accounting rules required the entire transaction value to be deferred and recognized ratably over multiple years.[iv] As a result, $888 million of deferred revenue was retrospectively added to AVID's 2010 balance sheet, which was to be amortized from 2011 to 2018. The recognition of this non-economic, non-cash accounting artifact has distorted AVID's financials because management has inexplicable refused to exclude it from adjusted results.

    II. A Framework Explaining Why Pre-2011 Revenue Amortization MUST be Excluded from Financials

    · A careful deconstruction of AVID's bookings model implies 96% of its pre-2011 deferred revenue would have been recognized by 2015. As such, the unscrupulous inclusion of this 100% margin accounting artifact is overstating AVID's adjusted revenue and EBITDA by approximately $91.5 million (2014) and $58.7 million (2015). We provide three illustrative models that clearly explain why pre-2011 revenue amortization is misleading and would not exist had AVID conformed to today's accounting standards.

    III. Management's Misleading Financial Metrics & More Potential SEC Reg G. Violations

    · We believe AVID management is misrepresenting the financial performance of its business by highlighting metrics that vastly overstate underlying fundamentals. AVID's presentation of its adjusted financials and key performance indicators appears to violate SEC regulations that prohibit the exclusion of recurring charges or adjusted financials that mislead investors.

    · Management's liberal definition of "Adjusted EBITDA" includes the amortization of deferred revenue from pre-2011 years, which is layered in at 100% margin. Because of this pro-forma shenanigan, the loss-making fundamentals of AVID are hidden. In 2014, AVID reported Adjusted EBITDA of $72.3 million. Excluding the $91.5 million of GAAP revenue that was booked prior to 2011, AVID would have reported negative recurring Adjusted EBITDA of $19.2 million. AVID appears to also be severely misrepresenting its recurring economic per share earnings. In 2014, AVID claimed to have made $1.30 per share; however, we calculate the adjusted EPS was actually a loss of ($1.03). Prospective debt investors appear to be calculating EBITDA in a similar manner as us, considering the effective interest rate on AVID's recent $100 million term loan commitment was 7.5%. Contrary to the 1.3x leverage implied by AVID's 2015 Adjusted EBITDA, we surmise the lenders (correctly) viewed AVID as 6.1x levered when stripping out the non-cash pre-2011 revenue amortization.

    · In what appears to be a violation of the spirit of SEC Regulation G, AVID reports "Free Cash Flow" that is actually "Adjusted Free Cash Flow." Management illogically continues to add back costs for restructurings initiated in 2012 and 2013, as well as restatement expenses even though AVID has been current on its filings since November 2014. In 2014, AVID reported a conventional free cash flow loss of $23.2 million (OCF - capex). However, AVID then added back $35.9 million of adjustments to report $12.7 million of free cash flow under its own definition. Since 4Q'13, AVID has added back $38.5 million of restatement-related expenses to FCF, more than twice what they had told investors ($15 - $20 million). In 1Q'15, nearly half of AVID's adjusted free cash flow was the result of add-backs from restatement/restructuring charges despite no ongoing restatement. AVID's FCF has also benefited from an unsustainable jump in deferred revenues. In 2014, post-2010 deferred revenues increased by 14%, which contributed $39.5 million to cash flow from operations (changes in pre-2011 deferred revenues do not impact cash flow). Changes in deferred revenue should ultimately track changes in bookings, with the latter declining year-over-year by 0.8% and 11.2% in 2014 and 1Q'15, respectively. Based on our analysis, we believe sustainable growth in deferred revenues should only contribute $8 - $10 million annually to cash flow from operations.

    · Management appears to be taking an extremely liberal approach to its definition of "Bookings." AVID includes "Backlog" additions in the bookings metric shared with investors as a KPI. Based on our analysis, we believe 15% of AVID's 2014 bookings were neither shipped nor invoiced. Further, we calculate that the actual conversion of 2014 "Backlog" into revenue was approximately 50% lower than the estimate management provided as late as September 2014. It appears that $37 million of the $74 million of expected backlog conversion management had filed in SEC documents was either "de-booked" or failed to convert. As such, we believe management has misrepresented its business momentum by imprudently characterizing pipeline as backlog, thereby artificially boosting reported bookings. Nondescript disclosures suggest AVID can recognize "bookings" despite no invoice. We believe management's spurious approach to reporting backlog resulted in a $30 million discrepancy between the backlog disclosed on the 3Q'14 earnings call and the same 3Q'14 backlog subsequently published in the 4Q'14 earnings release.

    IV. Repeated Failure to Disclose Material Non-Recurring Gains within Reported Non-GAAP Financials

    · In AVID's SEC filings, cash flow from operations shows $6.2 and $6.7 million of "Unrealized foreign currency transaction gains" in 4Q'14 and 1Q'15, respectively (emphasis added). We believe AVID has utilized an accounting treatment that misrepresents its financial profile by flowing FX transaction gains through the sales and marketing lines (as opposed to hedge accounting). Prior to the abnormal currency transaction gains in 4Q'14 and 1Q'15, AVID had not experienced more than a $1 million impact in the prior eleven quarters from its FX hedging transactions. Amazingly, AVID's Non-GAAP Operating Income, Net Income, and Adjusted EBITDA appear to include non-recurring FX gains without a single disclosure in the press release or earnings call. Assuming the abnormal FX transaction gains flowed through the income statement, AVID's reported Adjusted EBITDA would have been 44% (4Q'14) and 57% (1Q'15) lower, which we believe would have collapsed the stock price.

    · AVID appears to be recognizing abnormally large FX transaction gains "above the line," in the sales and marketing line. AVID's CFO publicly stated that 1Q'15 cost saving were attributed to "strategic initiative to drive to a leaner, more directed cost structure." Based on opaque disclosures in its 10Q, we believe AVID may have misrepresented the nature of its opex declines. In 1Q'15, AVID recognized a $2.2 million year-over-year benefit in its sales and marketing line from "Foreign exchange gains." As such, nearly half of the $4.6 million YoY improvement in opex appears to be non-operating in nature, which would directly contradict management's explanation.

    · After maintaining notional foreign exchange contracts (spot and forward) between $23.3 million and $39.5 million, AVID mysteriously discontinued its historical FX hedging practice and took the notional value to just $100,000 one month before 1Q'15 ended. Considering its foreign exchange exposures were unchanged, specifically the approximately 40% of revenue that comes from EMEA, we believe the sudden disappearance of hedging after large gains that were not disclosed in earnings calls and releases, warrants an explanation.

    · AVID used the terms "hedge" or "hedging" 33 times in its 10K while also explicitly stating foreign currency contracts are used "as a hedge against foreign exchange exposure." Nevertheless, AVID does not account for its hedges with hedge accounting. Instead, AVID records changes in the fair value of forward contracts in marketing and selling expenses, effectively booking gains in foreign currency contracts in its operating income and EBITDA. Despite appearing to be non-operating, non-recurring in nature, management does not appear to exclude these gains from its adjusted financials.

    V. More Financial Reporting Incongruities & Confusing Guidance

    · AVID's total deferred revenue balance published in its 3Q'14 earnings release of "$419,329" appears to have inexplicably been changed to "$417,337" in the subsequently published third quarter 10Q.

    · In its 4Q'14 earnings release, AVID guided free cash flow to "growth of $18 to $30 million." This exact same language was used in its 1Q'15 earnings release. AVID also guided free cash flow to a "42% to 136% year-on-year improvement" in 2015. Considering AVID reported $12.7 million of (heavily adjusted) free cash flow in 2014, its 42% to 136% growth guidance does not reconcile with "growth of $18 to $30 million." If this was a mistake, we would opine that frequent "slip-ups" are often a by-product of pervasive shenanigans in adjusted financial.

    VI. Was Management's Prior Sale of Open Solutions a Success or Absolute Disaster?

    · Analysts, investors, and AVID's very own management have highlighted that the CEO and CFO sold their last company for $1 billion in 2013. What investors are likely missing is that the $1 billion ($1.015 billion to be exact) was the value of the enterprise, which meant the equity was only worth $55 million when considering the associated $960 million of assumed debt. This would represent an equity value decline of 88% from the equity value just six years earlier (2007) if we hold the debt constant. The enterprise value appears to have experienced a 28% decline over six years leading up to the $1 billion "sale," while we estimate the revenue run-rate declined by approximately 29% from 2007 - 2013.

    · Two former executives (COO and Head of Marketing) at Open Solutions sued then CEO Louis Hernandez, as well as other officers, for withholding financial information and violating their duty of care and loyalty to shareholders. While we are always skeptical of litigation brought by former shareholders or employees, in the context of all of our other concerns, we do not believe it's imprudent to wonder if these allegations reflect a pattern.

    VII. Deteriorating Fundamentals & 2H-Loaded 2015 Guidance

    · Shenanigans aside, AVID's core business appears to be deteriorating and trending at a rate that is completely inconsistent with several "Non-GAAP" KPIs.

    · In the two quarters since being relisted, AVID has missed expectations for bookings, free cash flow, and revenues. AVID provided a highly misleading slide in its investor deck that shows a chart with revenue up and to the right. Yet, this chart contains no numbers or percentages on the y-axis, while also seemingly misrepresenting the factual story of bookings that declined 0.8% in 2014, compared to guidance for 3% growth. Our analysis suggests AVID missed its 4Q'14 implied bookings guidance by 10%. Further, 1Q'15 bookings declined by 11% YoY, which was significantly worse than AVID's full year guidance of (1%) to +3%.

    · AVID's management explained the horrid 1Q'15 results by suggesting several meaningful deals were pushed into 2Q'15 and had in fact already closed. As such, we can calculate that 2Q'15 revenue should be at least $138.5 million by adding the 1Q'15 shortfall to the pre-existing 2Q'15 sell-side estimate. Buy-side estimates for 2Q'15 will likely move even higher should AVID close its Orad acquisition before June 30, 2015. We believe management's faltering credibility will be impacted by its ability to hit buy-side estimates of $138.5 million for 2Q'15, NOT by the nonsensical consensus estimates that actually declined after 1Q'15 results pushed large deals into 2Q'15. [NOTE - It is well understood that 2015 estimates have yet to include the contribution from Orad. As such, AVID will need to revise its annual guidance when they report 2Q'15 by at least the $41 million revenue and $10M EBITDA post-synergy run-rates to which management alluded on the May, 7, 2015 update call].

    VIII. Fair Value is $5.53, Representing 69% Downside, Russell 2000 Buying Nearly Complete

    · AVID's stock price has decoupled from its economic reality, which we believe is due in part to a turnaround stock promotion, misleading financials, and disingenuous key performance metrics. We also believe AVID's stock price has benefitted from several months of unnatural buying related to the Russell 2000 rebalancing. Because AVID was removed from the Russell 2000 Index when it was delisted, the company will be added on June 26, 2015, after regaining its listing in late 2014. Based on estimates from Credit Suisse, net index demand resulted in 3.36 million shares of AVID's stock that needed to be bought. Assuming the arbitrage buying began in mid-March when preliminary rebalancing lists were released, we estimate Indexers (or arbs) have needed to buy roughly 48,000 shares of AVID per day for the last three months.

    · We believe consensus estimates have erroneously built forecasts for AVID without working through accounting nuances. By excluding pre-2011 deferred revenue amortization, and instead forecasting underlying driver metrics, we model financials that are starkly different than the sell-side. Using generous assumptions for revenue growth and margins, we expect AVID to generate $18.6 million of EBITDA and ($0.03) of EPS in 2017. Using a very generous EV/EBITDA multiple of 18.0x for 2016 and 10.4x for 2017 (the same 10x multiple a sell-side analyst uses), we believe fair value for AVID's stock is $5.53, which represents 69% downside from its current share price.

    [i] Credit Suisse estimates as illustrated in Table 46


    [iii] AVID Customer Tier Growth Strategy Presentation - May 2015

    [iv] AVID 1Q14 Earnings Call, September 9, 2014

    Tags: AVID
    Jun 24 10:45 AM | Link | 11 Comments
  • CONN Job? Substantial Downside Likely

    Today, we shared our opinion and research on Conn's. Below are the topics covered in our full report as well as the most important credit portfolio perspective that the retail sector bulls do not seem to understand. The full report can be found here:

    Conn's is a subprime finance company with deteriorating credit that is masquerading as a retailer. The thesis that Conn's will successfully unload its credit risk to an unsuspecting buyer, while retaining underwriting authority and servicing, appears deeply flawed. We believe no buyer is dumb enough to buy Conn's portfolio and cede underwriting & servicing back to Conn's. Without autonomy over credit creation, Conn's retail model is likely broken.

    Fair Value ~ $15.00 per share; 60% downside


    IMPORTANT Disclaimer - Please read this Disclaimer in its entirety before continuing to read our research opinion. You should do your own research and due diligence before making any investment decision with respect to securities covered herein. We strive to present information accurately and cite the sources and analysis that help form our opinion. As of the date this opinion is posted, the author of this report has a short position in the company covered herein and stands to realize gains in the event that the price of the stock declines. The author does not provide any advanced warning of future reports to others. Following publication of this report, the author may transact in the securities of the company, and may be long, short, or neutral at any time hereafter regardless of our initial opinion. To the best of our ability and belief, all information contained herein is accurate and reliable, and has been obtained from public sources we believe to be accurate and reliable. However, such information is presented "as is," without warranty of any kind - whether express or implied. The author of this report makes no representations, express or implied, as to the timeliness or completeness of any such information or with regard to the results to be obtained from its use. All expressions of opinion are subject to change without notice and the author does not undertake to update or supplement this report or any of the information contained herein. This is not an offer to buy any security, nor shall any security be offered or sold to any person, in any jurisdiction in which such offer would be unlawful under the securities laws of such jurisdiction.


    At first blush, the bull/bear debate on Conn's (NASDAQ:CONN) would appear well understood by all involved. Conn's is a battleground stock, with thoughtful investors holding extremely disparate views on the company's future. After spending an inordinate amount of time analyzing the credit side of Conn's, we believe substantial downside exists for reasons outside of the typical bull/bear debate.

    Today, the most important variable in the Conn's story is whether the company can successfully monetize the credit portfolio and negotiate a flow agreement. The word "and" is paramount in this discussion because a sale of the credit portfolio, without a flow agreement that allows Conn's to continue underwriting loose credit, destroys Conn's retail economics. Conn's stock has been aggressively bought by retail sector investors who foolishly believe the retail business would have greater stand-alone value independent from the credit side of the house. This new investor base, as well as the majority of retail sell-side analysts, does not appear to understand Conn's credit portfolio metrics, or the retail segment's reliance on in-house credit. The two businesses operate symbiotically and are heavily dependent on one another.

    The recent 35% run in Conn's stock began when management stated there were multiple parties interested in its credit portfolio. Amazingly, investors have equated the existence of interested parties with a favorable outcome. The fact multitude lenders want to diligence Conn's credit portfolio should not be surprising. The incentive to access Conn's data room for information is no different than public investors who look at an array of deals despite having minimal intent to buy. In today's easy money environment, where the thirst for yield often supersedes risk considerations, we concede that a dumb buyer may emerge. However, we believe any sale would come with highly restrictive terms on future underwriting. Should a sale be accompanied with restrictions on Conn's underwriting and servicing autonomy, any stock pop will be short lived. Without carte blanche discretion on aggressive financing, which we believe has resulted in a material overstatement of Conn's retail economics (an imbedded cost of financing allows Conn's to generate a 40.5% retail gross margin), Conn's retail model will break.

    Based on our analysis, we believe Conn's has disingenuously "window dressed" its credit portfolio, while subtly removing important disclosures from investor presentations. Despite wide ranging sell-side analysis of Conn's, the most important picture - cumulative loss curves - has somehow managed to escape scrutiny. Our analysis herein unequivocally illustrates why the consensus view of improving credit is false. We also detail nuances within Conn's credit portfolio and underwriting practices that have been neglected by investors, but will unlikely be overlooked by potential buyers. The market's assumption that a portfolio sale and flow agreement is a fait accompli has created significant downside risk for CONN investors should neither materialize. As such, we believe Conn's stock will retest the early 2015 lows around $15 per share, representing 60% near-term downside. In this report, we analyze the following issues:

    · Significant uncertainty persists on where credit losses and ultimate cumulative losses on recent vintages will normalize. The slope of the cumulative loss curves on the 2014 vintage is still steepening - meaning losses continue to accelerate. Based on a series of inaccurate forecasts and atrocious communication, it appears Conn's management has no idea where losses ultimately shake out. When Conn's reports its 1Q'16 report on 6/2/15, we expect the 2014 loss curves will already approach management's revised loss rate, which will make it clear that another increase in cumulative loss guidance is coming.

    · In 2013, Conn's claimed to make significant underwriting changes. The 2014 vintage should have partially benefitted from the underwriting changes, while the 2015 vintage should be reaping the full benefit of the changes. However, 2015 losses to-date are currently running higher than the disastrous 2014 vintage. Our presentation of cumulative loss curves is in direct conflict with the widely held view by retail sector investors and sell-side analysts that management's underwriting changes are driving credit improvements. When viewed through a credit portfolio lens, it is clear that the exact opposite is happening - losses are accelerating.

    · The optical improvement in Conn's delinquency rate is a function of normal seasonality, as well as financial sleight of hand. Historical delinquency rates at other subprime lenders trough around tax refund season and these same seasonal patterns have helped Conn's. In addition to seasonality, Conn's delinquency rate has been artificially suppressed by: a) the October 2014 decision to begin retaining no-interest, high FICO loans on balance sheet, b) management aggressively increasing the percentage of re-aged account balances, and c) significant charge-off growth. In the most recent quarter, re-aged accounts grew by 52% year-over-year, compared to 28% overall portfolio growth.[i] The quality of the re-aged accounts has also deteriorated significantly, with 93% growth in balances that have been re-aged at least six months and 98% growth in balances that have been re-aged between 3 - 6 months. Serving as a significant red flag to investors and potential buyers, Conn's changed its re-aging policy last year to increase the frequency that accounts can be re-aged by 33%.

    · A class action lawsuit makes salacious accusations against Conn's current management, including allegations that they knowingly misled investors. Former employees provide numerous examples illustrating Conn's renegade approach to its credit operations. Employees claimed Conn's would: extend up to $10,000 of credit to consumers with no credit scores; approve credit during the initial four to five months a new store was opened - even for customers with no income and FICO scores as low as 400; direct customers who had not been approved for credit at established Conn's location to newly opened stores since they would automatically be approved for credit; and "call [customers with declined credit] when a new store opened in their area and were told to apply for credit there." If true, the litany of inflammatory accusations would constitute violations of multiple U.S. laws, including: the CARD Act, Truth-in-Lending Act, Fair Credit Reporting Act, and the Credit Card Accountability, Responsibility & Disclosure ACT of 2009. A New York Times exposé corroborated many of the claims in the class action lawsuit. If Conn's management was this irresponsible with underwriting while receivables were on-balance sheet, we can only imagine how aggressive they might be in a flow agreement where a 3rd party assumed the ultimate credit risk.

    · A litany of regulatory issues (both present and future) would seem to present a material deterrent to prospective portfolio buyers. Just last week, the CFPB moved to regulate installment lenders, which will likely subject Conn's to much earlier than expected CFPB regulation. This follows on the heels of its March 2015 introduction of draconian regulation targeting the lending & collection practices of the payday loan industry. The CFPB has also asked for public comments on 12 "areas of concern" in the credit card market. Two significant financial drivers for Conn's, deferred interest and add-on products, appear to be under the CFPB's microscope. Deferred interest products comprise 33% of Conn's loan portfolio, while add-on products represent $50 million of high margin revenue in the credit card segment. Any credit portfolio buyer would presumably not only need to get comfortable with these looming regulatory risks, but also quantify the material economic risk on Conn's. Finally, the SEC's ongoing inquiry into Conn's has the potential to create even more uncertainty for a potential buyer. The class action lawsuit alleges that Conn's top two executives "possessed the motive to commit fraud [when they] reaped more than $4.5 million in insider trading proceeds." If true, the SEC will have obvious grounds to pursue enforcement actions.

    · We believe Conn's management and large investors have encouraged sell-side analysts to use Bluestem Brands as a proxy for a deal structure. This comparison appears misplaced. Bluestem originates and services loans retained by Santander Consumer USA (NYSE:SC). However, according to its amended 10K, only 30% of Bluestem's sales were financed through SC last year.[ii] This compares with approximately 89% of Conn's sales that rely on financing. Further, SC is not required to take all of Bluestem's loans, but instead has the "option to purchase certain loans."[iii] Conn' already has this type of third party relationship with Synchrony Financial (NYSE:SYF), who chose to finance just 10.8% of Conn's loans last year. Bluestem also appears to be far more attractive as a financing partner given a) less reliance on issues currently under the microscope of regulators, and b) strict ongoing regulation by the FDIC (their cards are issued through an FDIC insured bank). If an ultimate portfolio/flow agreement looks like Bluestem, we believe Conn's partner would only accept a minority of loans, while refusing to cede universal underwriting authority.




    Tags: CONN, BBY, HGG
    May 27 11:50 AM | Link | 7 Comments
  • BBSI - Garbage In, Garbage Out

    There is not a lot else that can be said as it relates to Barrett Business Services (NASDAQ:BBSI). You either blindly believe in the moving numbers and management that is self-proclaimed as strong as "tempered steel".... or you don't. While our arithmetic is fallible like everybody else with a spreadsheet, we at a minimum try to understand the garbage going in and coming out. This basic desire to understand how a guided number is built makes us a bit different than the two sell-side buddies of BBSI management.

    In its earnings press release, management guided 2015 EPS to $3.30 per share for 2015. Coincidently, this was precisely inline with the average of the two estimates ($3.31 to be precise based on estimates of $3.46 and $3.15). The basic drivers BBSI management provided lead to an EPS number that is starkly different (lower of course) than their inline headline number. The publicly stated disclosures include: 18% revenue growth, a workers' compensation accrual between 4.8% and 5% of gross revenue, and a mid-to-high 30's % tax rate. The company will have around $1.5 million of incremental interest expense based on their maturity schedule. Direct payroll costs and payroll taxes have been relatively consistent for years (and they are already benefiting from applying prior wages against the taxable wage basis as new customers are onboard). The only significant unknown variable is SG&A expense. On its fourth quarter 2014 conference call this morning, management stated that they plan to invest in additional business units, geographies, and related "structural and organizational build," which would seem to suggest continued SG&A growth. If we conservatively assume SG&A grows at a mere 14% (compared to 18% top-line guidance), then a basic model seems to calculate an earnings estimate of $2.25 per share at a 5% accrual. This is approximately 33% lower than management's guidance.

    (click to enlarge)

    Using the lower end of the accrual range (4.8%), we still calculate an earnings number of $2.94 per share, significantly below the $3.30 of guidance (see model at end of the document). It is worth noting that a number of incremental costs will now be flowing through the workers' compensation accrual. Management seemed to suggest that the incremental surety bond expense and letter of credit expense will now flow through the workers' compensation accrual. If their California surety bond covers the size of their reserves, or roughly $185 to $195 million, then this is a large probable step-up expense. In addition, ACE will collect full fronting fees and BBSI will have to pass through premium taxes to the State of California (PEOs avoided this tax prior to having their licenses revoked). We estimate that BBSI's "other workers' comp expense," which covers commissions, fronting, reinsurance and other expenses, was running near 1.6% of gross revenue in the second half of 2014. If this increases to only 1.7% with additional ACE costs and surety / line of credit expenses, management's 4.8% to 5% workers' compensation accrual guidance implies the claims expense accrual (what actually builds reserves to cover future workers' comp claims) would be running at, or below, the levels of 2009, 2011, 2012 and 2013. As we ultimately found out, those accrual levels resulted in BBSI being significantly under reserved. These years included a claims expense accrual of 2.37% to 3.11%, which increased significantly from the company's third quarter 2014 reserve charge. By comparison, we estimate the 2015 claims expense accrual implied in management's guidance will only be 2.52% to 2.72%. As such, we view the 4.8% to 5% accrual as an aggressive assumption.

    We can address BBSI's strained liquidity at a later date. However, we found it amusing (we'll avoid any stronger language) that management pointed to $25 million of restricted cash freeing up this year from California. This cash will only free up as they pay out $25 million of claims (so no real incremental cash flow from the balance sheet). We have previously pointed out that free cash flow is a highly questionable statistic for an insurance company that is growing their exposure in long-tail claim payments. Regardless, BBSI had roughly $65 million of free cash flow in 2014. Of this $65 million, more than $50 million was needed to fund the ACE trust account alone. Contributions into the ACE trust account could double in 2015, in which case a large negative cash flow hole would exist prior to the $25 million of Wells Fargo debt that is scheduled to mature. The only way BBSI we envision BBSI generating sufficient cash flow to fund its growing liabilities would be to continue to under price its workers' compensation business to attract new customers, with the hope claims expense down the road somehow improves. We continue to think this ends badly and believe shares have significant downside from current levels.

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    Tags: BBSI
    Feb 04 3:16 PM | Link | 3 Comments
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