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John Gutekunst
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John Gutekunst is a finance professional presently working in the United States for one of the world's largest banks as an analyst in its Corporate Lending department. John is also a CFA Charterholder. With his current employer, he has prepared analytical reports that helped obtain approval for... More
  • Devil's Advocate- Perspective From The Other Side On The Active Network 0 comments
    Feb 13, 2013 2:06 AM | about stocks: ACTV

    Disclosure: The author of this article is long ACTV

    BACKGROUND:

    Active is set to announce earnings on Thursday, February 14th at 430pm Eastern. This close to an earnings call, little movement in the stock can be expected. However, Active's share price has fallen 11.4% from its closing price of $6.03 on Friday (a period in which the broader markets have been relatively flat).

    The only major news article that arises on a google search for Active is an article posted on Seeking Alpha by Prescience Point ("PSP")- a boutique equity research firm whose website states that it specializes in short selling.

    SUMMARY:

    Active ("the Company") is under a bear raid by Prescience Point Research ("PSP", "the Firm"). I believe that certain items being emphasized by PSP are not presented in an objective manner. Specifically, I believe the following and provide details as to my rationale in this post:

    - I agree with PSP's analysis that Active's cash balances are not what they seem, however, Active provides sufficient disclosures for investors to incorporate this into their analysis

    - PSP's claim that Active is "hemorrhaging money" is inaccurate

    - PSP's claim that the Company is misrepresenting earnings is inaccurate

    - The deployment of the Company's cash after its IPO has been prudent and is not indicative of a uncontrollable cash burn

    - PSP's analysis of free cash flow fails exaggerates Active's negative FCF as it fails to consider the difference between maintenance capital expenditures and growth capital expenditures, and also does not incorporate the fact that Active can scale back R&D to improve free cash flow

    - Active's increased line of credit is rationale and justified (PSP claims there is "no explanation" for the increase)

    - PSP is clearly employing other typical tactics used by short sellers - Keep this in mind when reading the Firm's research reports. Tactics employed include:

    o The timing of the release of the Firm's lengthy research reports

    o Exaggeration or emphasis of events that are common to all corporations

    o Using emotional vocabulary and extreme adjectives in its publicly released research reports

    o Presenting and computing certain data points with methods that benefits a short-position

    o PSP's firm focuses primarily on short-sell recommendations which creates a bias towards its work that must be considered when using its analysis

    CONCLUSION:

    - Although the Firm's research appears to be affecting Active's stock price, PSP's research appears biased, exaggerates certain items, and makes some inaccurate claims. Therefore I do not put a lot of emphasis on its findings.

    - Given the Company's underlying earnings profile, leading market position, "sticky" nature of its revenues, the possibility of being acquired, likely overreaction and over-selling that occurred as a result of a growth outlook that did not materialize, and the outlook for gradual longer term revenue growth in the mid-single digit range; Active appears undervalued at today's prices for patient investors.

    HIGH-LEVEL VIEW ON ACTIVE:

    Before I provide rationale as to why I believe certain items outlined by Prescience Point are inaccurate or exaggerated, I want to state my general view of the Company to provide additional context for this post. None of my analysis indicates nor is intended to indicate that Active is a rock-star company poised to grow at incredibly fast rates over the near to medium term. Just ask any of Active's IPO investors what they think about the Company's growth prospectus (Active's May 2011 IPO price was $15.00).

    My analysis also does not indicate nor is it intended to indicate that Active has the most talented management team on the planet. Although I think the management team could help itself out by disclosing a few more items, disclosure overall and the management team's strategy appears good (not great, not poor) to me. The management team was clearly over-optimistic about its growth potential and presented an outlook to its investors that did not materialize, which has really hurt the stock since its IPO. However, I think many investors would agree that even though a company may not be expected to grow its top-line by double-digit levels and even though its management team has fumbled in the past, a company still may be worth buying depending on the circumstances. I believe this holds true for Active.

    HOW TO VIEW ACTIVE'S CASH BALANCES:

    Prescience Point ("PSP") accurately describes why Active's cash balances are not what they seem. To give an example, assume that one of Active's customers (IE: the NY Marathon) charges their participants a $20.00 registration fee and agrees pay Active $2.00 for each participant that registers using the Company's services. In this example, Active collects the full $20.00 directly from each NY Marathon participant, keeps it on the Company's balance sheet for a short period of time, and eventually remits $18.00 to the NY Marathon operators ($20.00 registration fee - $2.00 fee paid to Active = $18.00 remittance to Active's customer).

    Thus, the $20.00 sits on Active's balance sheet only for a short period of time, and is technically due to its customers. The amount due to its customers is called "Registration Fees Payable" ("RFP" in this post). I agree with Prescience Point, and believe RFP's should be netted against Active's cash balances.

    However, it is important to realize that Active provides disclosures to inform its investors of this dynamic. Specifically, under the "Registration Fees Payable" heading on page F-11 of the Company's 2011 10-k, Active states "Cash collected on behalf of customers is included in cash and cash equivalents prior to remitting the amounts owed to the Company's customers."

    Ø To the best of my knowledge, PSP does not cite these disclosures in either of Firm's two research reports issued in October 2012 and February 2013

    Ø On page 8 of PSP's October 2012 research report, the Firm uses the heading "Active Has No Excess Cash. None" above the section in which PSP describes these dynamics

    ACTIVE IS NOT "HEMORRHAGING MONEY"

    The simple example outlined in the last heading shows just how much cash is transferring through Active's account on an ongoing basis. PSP estimates that Active had over $1.6BN of cash move through its accounts during 2011 (see page 10 of its October 2012 report). This is much more than the Company's GAAP revenues, which were $337.4 million in the same year. Viewing these amounts simplistically, the $1.6BN can be viewed as the $20.00 fee paid by the NY Marathon participant in the prior example while the $337.4 million can be viewed as the $2.00 fee earned by Active plus smaller amounts of revenues from other services Active provides. To be clear, there are not any red-flags here. There are many businesses in different industries who report the net amount (IE: the $2.00 fee) as their GAAP Revenues (See FleetCor Technologies- FLT).

    When realizing a large amount of cash flows through Active's bank accounts, the $72.7 million of Registration Fees Payable ("RFP") reported on the Company's balance sheet at the end of September appears very reasonable. By my calculations, Active's RFP Days were 19.0 days (PSP claims payables days are 20.6- I'll touch the differences in our calculations later). This also is consistent with what Active states as far as the typical time it takes for the Company to remit the full registration fee to its customers. See page 41 of ACTV's 10-k in which it states the fee is "then remitted back to the [customer] typically on a two week basis".

    19-20 days is slightly longer than two weeks, but this is not significant in my opinion- especially when considering that most companies do something similar near quarter ends with their payables and timing of certain events could cause big swings in RFPs and RFP days (IE: what if a large event ended 1-day before the end of a quarter?). To me, I'm glad Active is pushing this to the limit. That's what management teams are supposed to do- place pressure on their suppliers if they have the bargaining power.

    What does all this mean?

    Similar to other entities that have a large amount of cash flow through their bank accounts relative to their earnings stream, Active is subject to significant working capital swings. To be clear, being exposed to working capital swings is a typical dynamic and business risk that many entities face, and is completely different than an entity that is "hemorrhaging cash".

    Importantly, Active's underlying earnings as measured by Adjusted EBITDA are sufficient to cover its fixed charges. Thus, Active is not burning cash. However, it may need financing for working capital swings depending on its growth and timing issues.

    Ø Read the tone of this section and the facts as I outlined them above. Then read how PSP presents this information. I'd love to hear your conclusion on this topic after you compare the two.

    ACTIVE IS NOT MISREPRESENTING EARNINGS

    See the information under the heading "Financial Statements Misleading at Best, Fabricated at Worst" in PSP's October 2012 report for context on my comments on this topic.

    In summary, I disagree with the significance of the change in RFP's relative to the changes "Total Due to Customers" (as described by PSP) and changes in registration volumes. Again, I believe timing of certain transactions can explain a lot of this. So long as Active's RFP days remain reasonable (which appears to be the case), I do not see this as a big red flag.

    PSP also provides a detailed argument that Active is reporting a portion of the gross revenues (IE: the $20.00 in the prior example) as its GAAP revenues. On page F-8 of its 2011 10-k, Active clearly states that "Revenue recognized on a gross basis comprised 0.7%, 0% and 0% of total net revenue for fiscal years 2011, 2010 and 2009, respectively". PSP also claims that Active should be providing these disclosures in its 10-Q's. However, given the relatively small amount of these transactions and the location of the disclosure in the 10-k, my experience is that most companies would not disclose this type of information to the public in its quarterly filings.

    ACTIVE'S USE OF POST-IPO CASH IS ACCEPTABLE:

    The majority of Active's excess cash from the IPO has been used to repay debt, acquire entities to grow, and reinvested in the business via capital expenditures and R&D. For a relatively new company (Active was only $44.2MM of revenues in 2005), this is exactly where you would want to see a company allocate its capital. Reinvesting in the Company in all of these forms is important for the long-term viability of a newly formed entity.

    Ø Keep this in mind while reading PSP's discussion about the change in Active's cash position after the IPO.

    PRESCIENCE POINT EXAGGERATES THE MEANING OF ACTIVE'S NEGATIVE FREE CASH FLOW

    Similar to the comments in the previous section, Active is a relatively new company and is reinvesting into the business. As such, break-even Free Cash Flow (Operating cash flow minus capital expenditures) should be expected, and the majority of Active's capital expenditures are likely discretionary and related to growth at this point in time. If the Company's maintenance capital expenditures were used in PSP's analysis, Active would likely be Free Cash Flow positive (unfortunately Active does not provide maintenance capex). Furthermore, Active has the ability to scale back R&D. At $61MM during 2011, a 10-20% decrease in these expenditures would generate significant free cash flow (and also improve profit margins).

    Ø PSP claims that Active is "Burning Free Cash at Significant Rate" (Page 9 of October 2012 Report)

    USAGE ON THE RLOC BETWEEN QUARTERS IS NOT MEANINGFUL

    To begin, it must be emphasized that PSP elected to use Q3 2012's interest expense vs. YTD 9m 2012 interest expense for its calculations. Annualizing Active's YTD (nine-month) interest expense of $480,000 would be much less than annualizing Q3 2012's interest expense of $239,000.

    Regardless of this point, there isn't any alarming information provided by this type of analysis. It does appear as if Active utilizes its $100 million revolving line of credit ("RLOC") at times in between quarter-ends. However, usage on the RLOC is clearly justified by the large working capital swings Active is exposed to (as discussed previously), and it appears as if at times the Company relies on the RLOC to fund some of the RFPs to its customers. That is not an alarming issue in my opinion.

    THE SIZE AND INCREEASE TO THE COMPANY'S RLOC IS EXPLAINABLE

    On page 8 of its October 2012 report, PSP claims that Active "doubled its line of credit with no explanation". Again, the nature of the working capital demands created by the RFP's combined with Active's business growth provides an explanation for the increase from $50 million to $100 million. Notably, $100 million appears reasonable relative to the $72.7 million of RFP's. Also, the credit markets in the corporate lending area have been very strong (I spend my daily professional life in this space), so it is likely Active elected to take advantage of these favorable credit markets.

    PRESCIENCE POINT IS EMPLOYING NUMEROUS (TYPICAL) SHORT-SELLER TACTICS

    PSP is an Experienced Short Seller that knows all the tricks when it finds something that it believes should or could fall in price. Keep in mind that investors don't always need to be right- sometimes they just need a good enough story to tell and enough things to latch on to. All good investors are good salesman and know how to emphasize certain points to sell their story or point of view. However, like many salesman, sometimes points or facts emphasized are misunderstood or even insignificant.

    A summary of the tactics employed by PSP include the following:

    The timing of the release of its research reports:

    Through PSP's posting on SeekingAlpha.com and the Firm's website, Tuesday was the second consecutive quarter in which PSP has released a thorough research note only a few days prior to Active's scheduled earnings announcement. PSP initiated its coverage on October 31, 2012 (one day before Active's Q3 2011 earnings release), providing a 35-page report outlining the Firm's rationale for a strong sell recommendation on Active. The timing of these releases is typical for short-sellers, as it gives companies little time to adjust the script they had been preparing and likely finalized for their already scheduled earnings call.

    Using vocabulary to elicit emotion in its research

    One primary key to a successful short-sell is creating enough fear for cautious investors to stay on the sidelines and cause present investors to take their money and run. One of the primary methods some short sellers use to do this is incorporate strong language in their research with extreme adjectives or bold claims, especially in their headings for certain sections. I've touched on a few of these in this post and I'm sure you'll see what I'm talking about when you read PSP's reports. Here are a few more for reference:

    PSP's February report includes in the title "Structural Insolvency"

    "management did not reply until 6 days later" (Oct. Report- page 6)

    "inexplicable irregularities" . . . "severely dislocated" . . . (Oct. Report- page 6)

    "rapidly burned through its strong, post-IPO excess cash position" (Oct. Report- page 8)

    "Active has no excess cash. None" (Oct. Report- page 8)

    Headings such as "Red Flag Warning Signs…" Oct. Report- page 8)

    Computing Data with a Bias towards their story

    I briefly touched on how PSP annualized 3m interest expense vs. 9m interest expense. That is one example. Another example is that PSP uses the period-end RFP balance when computing RFP days. The best-practice is to use an average of the previous two periods. Using only the period-end results in higher RFP days, which favors PSP's story.

    Prescience's primary focus is on short selling opportunities

    I think excerpts from the Firm's website speak for itself as far as what it is known for:

    "Together, the founders have over 25 years of combined Wall Street experience, and a significant track-record of successful short recommendations. The sole focus of our company is to conduct comprehensive fundamental research, and uncover companies that are engaging in fraudulent or misleading business practices".

    Maybe they've found one in Active that's misleading, or maybe they've found one that they could sell as misleading even though it isn't. I think you know my stance on Active.

    Disclosure: I am long ACTV.

    Stocks: ACTV
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