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quietjames
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Trained value investor. Bottom-up stock picker with a tire-kicking approach. Boston based freelance equity researcher available for short or long-term work assignments. If interested and from an established firm, contact me from a credible email address.
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  • A Self-Dealing Management Team?
    Full Disclosure: I am short MRGE stock.

    "Read not to accept, nor reject, but to weigh and consider." - Francis Bacon

    The following information was extracted from the 2010 10k, the 2011 Q2 report, and the most recent proxy filing. I encourage all to check my calculations and methodology, but I fully believe that you'll find I am providing an accurate portrayal of the economics of what has gone on. I believe the MRGE management team is charismatic, friendly, and persuasive. And I also believe it has engaged in a number of transactions with questionable motives.

    With majority ownership of MRGE and a large representation on its board of directors, Merrick LLC, a private equity firm, has substantial influence and seems to put its own economic interests above those of the other common shareholders. Merge has seven board members, four of which are either affiliates of Merrick, of Merge or of both companies. Merrick's CEO, Michael W. Ferro Jr., serves as chairman of Merge's board of directors. Justin Dearborn, MRGE's President and CFO is a former affiliate of Merrick. Board member Gregg Hartenmayer has served as an advisor to Merrick, and Merge's CEO, Jeff Surges, is also on the board. With full disclosure and in plain sight, it appears that management (Merrick) has engaged in what, in my opinion, seems to be corporate mismanagement and self-dealing for the benefit of itself at the cost of other shareholders. Here are two transactions that Merrick was party to.

    In April of 2010 Merrick issued preferred stock to itself and a few select other qualified investors at an alarmingly steep discount to face value, thereby giving itself and the other original buyers abnormally high returns with the cost borne to other shareholders.

    First, the transaction: In exchange for total proceeds of $41,750,000, 41,750 shares of preferred stock and 7,515,000 shares of common stock were issued. The preferred shares accrued an annual 15% dividend, and management said their valuation was performed by an independent consultant.

    Let's allocated the $41,750,000 between the two classes of shares as MRGE did, but this time let's use the average market price of MRGE stock in the prior month in our calculations. The average market price of MRGE stock in March of 2010 was $2.18. So the common stock issued had an approximate value of $16,382,700 (7,515,000 shares x $2.18 per share). Subtracting this value from $41,750,000 gives $25,367,300 of value that would then be allocated to the preferred shares. Dividing $25,367,300 by 41,750 shares of preferred gives a purchase price of $607.60 per preferred share. This is equal to a 39% discount from the $1,000 redemption value. (In the 10-k management estimated they were issued at about $643/share. It all depends on what you think the common stock component is worth. I have disclosed my reasoning. Then the residual amount is assigned to the preferred component.) Now, the preferred shares were privately placed, which means that they don't trade freely, so an illiquidity discount to par value could be justified. But 39%? Especially when management, who controls the timing of their redemption, also owns the shares and would benefit in such circumstances?

    Continuing, so according to my estimates the preferred shares were issued at approximately 61% (again, $607.60/share) of their $1,000/share redemption value. Then the shares were redeemed just 14 months after they were issued, giving Merrick and any other original preferred shareholder a 93.5% return (($1,000 redemption value per share + $175.5 accrued dividends per share)/ $607.60 purchase price per share ). See the 10Q for Q2 of this year where this is disclosed but not as clearly as I have done above. Merrick owned 10,000 shares, so the round trip transaction netted them $5,679,000 over the course of 14 months. That is, 10,000 shares x ($1,175.5/share total redemption proceeds - $607.6/purchase price). Impressive.

    Surely there were cheaper financing alternatives available than issuing the preferreds at such a steep discount. Even a public common equity raise would not have been so costly. Also, why wasn't the entire issue composed of common stock rather than a fraction of it? Were the deep discount preferreds used to sweeten the deal to the other knowledgeable buyers? Lastly, if Merrick was concerned about losing voting control, then a rights offering would have been appropriate. There's more to this transaction though.

    The preferred shares were repaid using the proceeds from $52 million in additional debt at 11.5%. Effectively management substituted $52 million in debt for $41.75 million in preferred stock. Even without this added debt burden the company was struggling to cover its existing $200 million debt obligations. Interest coverage as defined by (CFO + Interest expense)/Interest expense for the last four quarters had been 0.2, 2.1, 0.9, and 1.7, respectively. Was this really a time to be taking out more debt? On the Q2 call management said they did this (swapped the preferred for debt) "in order to improve the long-term cash flow of the company." I do not believe this is an accurate statement. I believe management (Merrick) did this to get a 93.5% return - $5,679,000 - over 14 months. While the coupon rate on the debt was lower than the 15% preferred dividend, the difference in financial flexibility is dramatic. Miss a preferred dividend, no big deal. It just cumulates. Miss a coupon payment and you're filing for bankruptcy protection. Leaving the preferred shares outstanding would have been the prudent thing to do, but that would not have provided Merrick with $5,679,000 in such a short time.

    Assuming the preferred shares are never redeemed means the minimum annual financial cost is 24.7%: $150 per year (par value of $1,000 x 15%) divided by the proceeds per share of roughly $607.6. If the preferreds are redeemed, then they must be redeemed at $1,000 plus any accrued dividends. If they are redeemed as early as 1 year later (ignoring the early retirement feature that was eventually relaxed), then they cost equityholders an 89.3% annual financing charge (($1000 redemption value + $150 accrued dividend) / $607.6 proceeds from issuance) -1). So depending on the timing of the redemption, the explicit annual cost of the preferreds is somewhere between 24.7% and 89.3%. As I've already said, surely there were cheaper, more shareholder friendly - friendly to all shareholders that is - financing arrangements.

    In light of the above transactions, management not being forthright about the composition of Q3 revenue, and the quiet, timely filing of the shelf registration statement only two days after the Q3 call - all things that I have previously published about - I wonder if investors will take notice and start to view management as a little less credible than before. I know I have. And it should come to us as no surprise that the street analysts have been silent on all these issues. Objective analysis is no way to win I-banking business.

    Disclosure: I am short MRGE.

    Feb 22 1:38 PM | Link | 1 Comment
  • Don't Know? Just Count.
    Full Disclosure: I am short the stock.

    For the second conference call in a row, when asked about OIS revenue contribution, CEO Jeff Surges dodged the question. On the Q3 call Mr. Surges said OIS didn't contribute anything and last Thursday on the Q4 call he said that it is difficult to estimate how much came from OIS and therefore he really couldn't say.

    OIS makes ophthalmology imaging and informatics systems that, one would imagine, are easily distinguishable from MRGE's other portfolio of offerings. Is it that hard to simply count the number of product sales of the OIS type and any related maintenance/support revenue and add it all up? Or does MRGE not have such internal control procedures?

    Only with the help of the $30 million dollar OIS acquisition was MRGE able to "hit" the revenue numbers again. The press has it wrong, and I maintain my stance that this quarter was again a clear and substantial revenue miss. Simple math shows this. See my previous posts.

    Would it kill management to provide the requested numbers? No, but it might just kill the stock price.

    I believe this management team is keenly aware of how important public perception is, especially when your company is highly levered and has stock that is priced to perfection.

    The market has voted to ignore the points I raise about the top line, but the share counts continue to increase. Luckily for MRGE, continuing to have negative income, higher share counts actually bolster its reported GAAP EPS as losses get spread among a larger share base, making it less negative on a per-share basis.

    Disclosure: I am short MRGE.

    Feb 18 5:08 PM | Link | 1 Comment
  • Lackluster Q4 Results
    Full Disclusre: I am short the stock.

    Last night MRGE released its fourth quarter and full year results. In my opinion, the actual reported results fall well short of a what investors would expect for a stock that trades so rich.

    Reported Q4 GAAP revenue = $64.1 million.
    Estimated Q4 OIS acquisition contribution = $3.5 million
    Estimated Q4 organic GAAP revenue = $60.6 million
    Q3 reported revenue (all organic according to managenment) = $60.1 million.
    Estimated organic dollar growth from Q3 to Q4 = $0.5 million

    Consensus organic revenue expections for Q4 = $64.5 million
    Estimated organic reported revenue = $60.6 million
    Negative surprise/revenue miss = ($3.9) million.

    Q4 GAAP EPS = ($0.01)
    Q4 Reported CFO/share = ($0.05)
    Q4 Reported FCF/share = ($0.06)

    Management continues to emphasize new deals and top line growth, but the company continues to lack the ability to convert these to meaningful GAAP EPS profits and cash flow per share.

    Disclosure: I am short MRGE.

    Feb 16 8:24 AM | Link | Comment!
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