Company: Osiris Therapeutics (NASDAQ:OSIR)
Share price: $8.50
Market Cap: $300 million
LTM Rev: $88 million
LTM Net Income: $1.9 million
P/E ratio: 175x
Author's note on use of the word "fraud"
As of this writing, I currently have over 3,200 followers on Seeking Alpha. These readers have no doubt come to realize that I tend to cover shorting opportunities where companies are doing something wrong. I do not simply focus on overvalued stocks. But readers should also be aware that I very seldom ever use the word "fraud" even when there are many red flags which might otherwise justify such use. I am very careful with using the word "fraud".
The last time I came out and used the word "fraud" was when I wrote about ForceField Energy (NASDAQ:OTC:FNRG). The stock had been trading at around $7.80, but cratered by nearly 30% on the day of my article. This prompted the company to issue a forceful response against me. The company promised a full business update and rebuttal for the following Monday. By Monday, the stock was down by a full 60% and the only update the company could provide was that the chairman of ForceField had been arrested by the FBI at the airport in Miami while trying to flee the country. The stock was immediately halted. It has since resumed trading at around 1-2 cents. Down 99%.
Even while the stock was halted, we can see that there were numerous retail investors posting comments in support of ForceField at the bottom of my article. Those investors would have clearly lost around 99% of their money by refusing to get out of an obvious fraud.
I would strongly encourage readers of this article to read those positive comments at the bottom of my article on ForceField. I expect to see similar positive comments on Osiris. I also expect that those who are still supporting Osiris in the face of very obvious problems are about to be sorely disappointed
There are two points to be made here. First, I only use the word "fraud" when I see something egregiously wrong with a company. Second, when a fraud comes unraveled, the implosion is often swift and brutal and provides little to no opportunity to get out. With thousands of other stocks to own out there, there is simply no reason to hold on to a stock that has even a hint of fraud about it.
Background on Osiris Therapeutics
There are many existing red flags on Osiris. The CFO has already resigned and been replaced. The auditor (BDO) has also resigned and been replaced. Internal accounting controls have already been deemed to be ineffective. Research analysts have switched from "buy" to "sell". The company's receivables DSO ("Days Sales Outstanding") balance has exploded to over 130 days, despite assurances from the company that it should be declining. There are blatant inconsistencies between various SEC filings, as well as inconsistencies between statements made by management and information contained in filings. These appear to have led to the auditor's resignation. We can also see that Osiris' largest competitor is publicly calling into question the supposed revenues being generated by Osiris using independent market data.
Former auditor BDO first required multiple restatements of past financials due to improper recognition of revenue. The auditor then took the highly unusual step of requiring Osiris to begin recognizing certain revenues on a "cash basis", only once actual cash had been received. Osiris' newly appointed CFO assured us that the damage was done and there would be no more issues. Shortly thereafter, auditor BDO resigned altogether. Osiris didn't disclose the resignation of its auditor for a full week, and then only disclosed the resignation once a new auditor had been appointed. This limited the damage to the stock price.
But prior to the resignation, the auditor also required some new disclosure:
On occasion, customers purchase product and request that the Company store the purchased product in segregated freezers at the Company's facility.
In other words, the supposedly "sold" product is not even being delivered to the customer.
Moreover, we know from the company's receivables disclosure that most of the product is sold on very generous extended payment terms.
So what the disclosure above means is this: in certain circumstances, no product changes hands AND no money changes hands, yet Osiris still recognizes revenues from supposed product sales.
Such an arrangement is downright absurd. Osiris is merely manufacturing revenues when no sales are actually occurring in reality.
The tip off about these irregularities is that Osiris' DSO balance now exceeds 130 days. This is more than double the average of competitors and is well in excess of what even Osiris itself considers to be delinquent payment by its customers. Osiris discloses that payments which are due more than 45 days are considered delinquent. So it is safe to say that the majority of receivables are delinquent.
If we had no more information than that above, Osiris would be a very attractive short candidate. Osiris has appointed Big 4 auditor E&Y in an attempt to instill confidence with investors. But as we have seen in the past (examples provided below), when troubled companies appoint Big 4 auditors, these auditors are even more likely to uncover problems, and are just as quick to resign. Based on the analysis below, I see very little chance that Osiris will be able to issue its annual 10-K filing. I fully expect E&Y to become aware of the problems below and to resign before the annual report is due. Or at a minimum, there will be further substantial restatements.
Osiris has $43 million in cash (about $1.23 per share) and does generate some revenue (but almost no profit). As a result, the stock is not likely to be a true "zero". Instead we should expect the stock to trade at around $2-$3 based on restatements or auditor resignation.
What does Osiris do?
Osiris produces three types of human tissue products. The company's main product is Grafix, which is basically frozen tissue derived from donated human placentas. The product is used for wound care, including burns and diabetic foot ulcers. Osiris does not disclose the breakdown of its product sales, but analysts estimate that 90%-95% of revenues come from the sale of Grafix alone.
Osiris also produces a cartilage allograft known as Cartiform, which accounts for minimal sales.
Finally, the company produces a bone allograft which is currently known as BIO4. The bone allograft was originally produced using placental membranes and was known as Ovation. But the FDA ruled against the production of Ovation and required Osiris to stop producing and marketing the product. Rather than destroy the remaining inventory, Osiris took a very unusual step. Osiris handed all remaining inventory to several distributors and told them to simply pay for it once they could eventually sell it. So even though the FDA ruled against it, Osiris found a way to keep selling the product.
Since that time, Osiris has made substantial changes to the bone allograft product. It is now made from bone tissue rather than from placental tissue. The new product is known as BIO4.
A closer look at Stability Biologics
As part of my due diligence, I began identifying and contacting multiple distributors who do business with Osiris. The largest of these is Stability Biologics. As will be shown below, there is considerable uncertainty as to just how much business Stability actually does with Osiris. This is due to blatant inconsistencies within Osiris' SEC filings.
But in any event, Stability was most recently listed in the 10-Q as being responsible for 11% of Osiris' revenues. And we can see that Stability was just bought by MiMedx (NASDAQ:MDXG), creating a gaping revenue hole for Osiris.
It also means that the past channel stuffing must now come to an abrupt end, with revenues set for a steep drop.
We know that Stability was Osiris' largest customer because it is the only one that Osiris discloses in its SEC filings. But we quickly run into problems quantifying it. This is because the SEC filings from quarter to quarter provide wildly differing numbers - even for the identical quarters.
In Q1 of 2014, Osiris claimed that Stability accounted for fully 58% of its revenues that quarter. But if we then look at the 10-Q for 2015 (which shows revenues from Q1 2015 and Q1 2014) we can see that Osiris now says that in Q1 of 2014 (i.e. the same exact quarter), Stability only accounted for 15% of revenues.
Here is the text from each 10-Q:
From the 1Q 2014 10-Q (page 10):
During the first fiscal quarters of fiscal 2014 and 2013, revenues from one of the distributors of our Biosurgery products, Stability Biologics, comprised approximately 58% and 64%, respectively, of our total Biosurgery product revenues.
From the 1Q 2015 10-Q (page 11):
During the first fiscal quarters of fiscal 2015 and 2014, revenues from one of the distributors of our Biosurgery products, Stability Biologics, comprised approximately 13% and 15%, respectively, of our total Biosurgery product revenues.
Something is clearly very wrong with the sales that supposedly went to Stability. This is most likely one of the factors which led to the resignation by BDO.
Why did auditor BDO resign from Osiris?
Concurrent with the release of its 3Q 2015 financials, Osiris announced that it was restating past financial results for multiple quarters because there was
lack of sufficient evidence of the contractual arrangements to satisfy the applicable auditing standards, which is necessary to recognize revenue on an accrual basis under GAAP.
In short, Osiris was improperly recognizing revenues. Simple as that.
On the quarterly conference call, Piper analyst Ted Tenthoff asked:
should we anticipate any other changes during the quarter or does this pretty much bring this issue to a close?
New CFO Greg Law responded that:
It's bringing the issue to a close.
While CEO Dr. Lode Debrabandere stated that:
Remember Ted that we absolutely discontinue duration in 2014, so that will cost a very, very vast kind of sound observation and so that makes it all come to a closure and be done with it.
But it wasn't done. Not by any means. In fact, things were about to get much worse.
Just a few days later, Osiris released an 8-K noting that auditor BDO had now deemed its internal controls to be ineffective. Details of this change were analyzed by author Edward Vranic in his own article.
As of this time, BDO was continuing to raise serious concerns but had not yet resigned.
But then the company presented at a Canaccord conference and was questioned by several audience members on receivables. The audio for this conference can be found here.
First, new CFO Greg Law sought to reassure the conference that there would be no more restatements, stating:
So are we done? I believe we are done.
But it was the statements made by the CEO (at approximately 8:50 into the audio) that likely led to the swift resignation of auditor BDO.
In response to a question on receivables, CEO Dr. Lode Debrabandere stated that:
For example, PhysioRx, we have publicly stated that we booked $1.1 million in the fourth quarter of 2014. Of that, $1.1 million, $800,000 has been received already in cash, and the remaining $300,000 is expected before this year end. So, that is pretty much done. There is still a $0.7 million order out there of PhysioRx from the first quarter. And then there is the Stability acquisition of Ovation from the 4th quarter of 2014 that makes up to the about $7 million total.
These comments are crucial and are most likely what led to the resignation of auditor BDO.
So what the CEO is telling us is that there is about $1 million of receivables coming in from PhysioRx and at least $6 million coming in from Stability.
But we can see from the most recent 10-Q that Stability only accounts for 2% of accounts receivable, just $757,000. So what Osiris has already disclosed to investors ($757,000) is nowhere near the level which is being stated by the CEO (at least $6 million).
These amounts come from a single distributor and amount to at least 10% of the revenue which Osiris reported to-date in 2015.
The statements regarding Stability are wildly at odds with what Osiris discloses in its SEC filings. Within a few days of these statements from the CEO, auditor BDO suddenly resigned. (Despite the repeated assurances from the CEO and CFO that we were "done" with accounting issues.)
Appointing a new auditor
When a troubled company appoints a Big 4 auditor, it should actually be viewed as more cause for concern than cause for relief. We have seen this consistently around the world in China, the US and Japan.
Back in 2010 and 2011, there was a wave of auditor resignations among US listed Chinese companies. Even the companies which had not yet faced an auditor resignation still faced a crisis of confidence and plunging share prices.
As a result, a number of these companies sought to reassure investors by appointing Big 4 auditors. The ruse worked for a few months and the share prices soared - even though a number of these companies were entirely fraudulent.
But what happened was that ultimately the Big 4 auditors were even more stringent that their smaller predecessors and when it came time to put out a 10-K, the Big 4 auditors found even more problems and simply refused to sign off.
We saw this repeatedly on Chinese companies including Wonder Automotive (formerly WATG) where newly appointed PWC resigned, Subaye (formerly SBAY) where newly appointed PWC resigned and Duoyuan Printing (formerly DYP) where newly appointed Deloitte resigned.
We have also seen similar "upgrades" followed by auditor resignations with US companies. This includes EBIX (NASDAQ:EBIX) and Advanced Emissions (NASDAQ:ADES) which upgraded to KPMG only to have them resign. We saw the same thing with NATURE S SUNSHINE (NASDAQ:NATR) in the US when E&Y resigned.
The point is that former auditor BDO suddenly found ample problems to justifying resigning. A Big 4 auditor is almost certain to find all of these problems, and possibly more, prior to the release of a 10-K.
The outcomes I expect from here are either that E&Y will simply resign, or they will again require massive restatements due to the inconsistencies described above.
Third party accusations of fraud?
The fundamental questions to the fraud thesis are: is Osiris overstating revenues? If so, by how much?
It is unusual that Osiris does not disclose any breakdown of revenues between its products. However, analysts estimate that 90%-95% of revenues come from the Grafix product alone. It is almost everything.
The main competitor and market leader in the wound care space is MiMedx. MiMedx has already come out in two public statements formally stating that Osiris is overstating its revenues.
From the MiMedx Q3 conference call:
Generally speaking, we find our data to be reasonably accurate with occasional acceptance for some companies that do not publicly disclose the product line breakouts. For example, we've analyzed the Medicare 2014 claims data for the hospital outpatient market. This data shows that in 2014, MiMedx had the market leadership position with 34%, Organogenesis was next at 31% and Osiris was at just under 8%.
Now this Medicare data tells us that the SmartTrack data for MiMedx and Organogenesis are reasonably consistent with the Medicare data. With the SmartTrack, Osiris data is very likely significantly overstated. Our SmartTrack data shows Osiris at about half or 50% of our wound care revenues. The sales in the category are most likely closer to 20% of ours in wound care based on the calculations from the Medicare data.
Separately, in a recent letter to shareholders, MiMedx stated the following:
We have previously presented the Medicare and commercial payer data on the Grafix product as well as other competitors. Osiris has refused to give its shareholders any revenue breakdown. They like to create the myth that their revenue is largely competitive with our EpiFix product in the advanced wound care sector. That is not the case. There is information from Medicare, the Veterans Administration and from commercial payers showing that Grafix revenues are approximately 20% of our EpiFix revenues.
How can these discrepancies be explained? It is simple. Osiris is recognizing revenues in exchange for receivables. The products simply sit at the distributors and are never being sold to the end market. And unfortunately Osiris is never getting paid. We can see this from the DSO balance which now exceeds 130 days.
But now that Osiris' largest customer has been sold to Osiris' largest competitor, the scheme must come unraveled and reported revenues will plunge.
Conclusion: What is Osiris doing wrong?
Osiris has consistently been improperly recognizing revenues. That much should be clear. This has inflated both the absolute dollar about of revenues as well as the perceived growth rate.
Osiris has only begun to get caught. Before resigning, former auditor BDO required restatement of 3 quarters of revenues for PhysioRx, and required PhysioRx to be treated on a cash only basis.
But PhysioRx has always been a tiny customer, accounting for roughly $1 million in any disclosed quarter.
Stability Bio is a much bigger deal. It is likely the problems with Stability that resulted in the auditor's resignation. This can be gleaned from the timing of the resignation vs. the comments made to audience members at Canaccord.
We know that Stability was a major customer, but many of the disclosures which quantify this are contradictory. This is a major problem.
At one point, Osiris disclosed that Stability was responsible for 58% of revenues in Q1 of 2014. Later, Osiris stated that it was just 15% of revenues in that same quarter. The difference is clearly massive and yet no explanation or reconciliation has been provided.
Separately, at a recent conference, the CEO stated that Stability was responsible for around $6 million of receivables owed to Osiris. Yet the most recent 10-Q puts that amount at just $757,000. It should be viewed as telling that the auditor resigned shortly after these statements were made.
Auditor BDO resigned on December 11th. However, Osiris deliberately did not notify investors of the resignation until 1 week later, once it had already appointed a new auditor, the Big 4 E&Y. But given Osiris' past troubles, investors should be feeling more concern rather than comfort over the appointment of E&Y. E&Y is virtually certain to encounter the same issues that led to BDO's resignation as well as additional issues regarding receivables.
Competitor MiMedx has repeatedly cited Medicare and VA data, accusing Osiris of overstating revenues by 2-3x. What is most likely happening here is that Osiris is offloading inventory onto various distributors (including Stability). This inventory is never sold, resulting in the exploding receivable balance at Osiris. But Osiris still books the sales anyway, inflating revenues.
Osiris is still valued at around $300 million, despite the fact that it struggles to achieve any profitability. An auditor resignation or massive restatement is highly likely, which would send the stock to around $2-3 in short order.
Disclosure: I am/we are short OSIR.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The author was previously an investment banker for a major global investment bank and was engaged in investment banking transactions with a wide range of healthcare companies including medical device, pharmaceutical, genomics and biotech companies. The author has not been engaged in any investment banking transactions with US listed companies during the past 5 years. The author is not a registered financial advisor and does not purport to provide investment advice regarding decisions to buy, sell or hold any security. The author currently holds a short interest in OSIR and during the past 12 months has shared his fundamental and/or technical research with investors who hold a short position in the stock. The author may choose to transact in securities of one or more companies mentioned within this article within the next 72 hours. Before making any decision to buy, sell or hold any security mentioned in this article, investors should consult with their financial adviser. The author has relied upon publicly available information gathered from sources, which are believed to be reliable and has included links to various sources of information within this article. However, while the author believes these sources to be reliable, the author provides no guarantee either expressly or implied
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