The Reason Wall Street Is Blanking PLUG's Accounting Problems
Summary
- A colossal of law firms are banding on a class action lawsuit against Plug Power, accusing the company of misleading investors.
- Statistically, almost half of securities class action lawsuits are dismissed.
- The reclassification of R&D as COGS will not have a material impact on gross margins. Still, all told, the company has work to do in this regard.
Investment Thesis
The recently announced accounting errors have an immaterial impact on Plug Power's investment thesis, which centers on growth in the number of units sold and subsequent economics of scale that would enable the company to achieve gross margin targets.
The recent Class Action is manageable, given the company's cash position and probability of being dismissed. The plaintiff's main argument is that the company withheld information from shareholders, which, given the line of events, is a hard pill to swallow. If the company knew it had to reinstate the financial statements, it wouldn't have convened a conference call for the fourth quarter. I believe that the company follows its external auditor's lead, who has been part of the necessary financial engineering that reflects the company's complex operating environment.
The Class Action
More than 20 law firms are banding together on a class action suit against Plug Power (NASDAQ:PLUG) after the company notified the SEC of accounting errors in previous financial statements. I believe the issue will boil to whether PLUG management withheld information from shareholders. The class-action suit covers investors investing in the period between November 9, 2020, " a day after the company filed its Q3 statement" until March 1, 2021, "the Q4 deadline". PLUG became an accelerated filer in December 2020, and as a result, was required to file an annual statement on March 1, 2021.
I believe that PLUG management wasn't aware of the need to reinstate the previous statements. The company announced Q4 results on February 25 and, only six days later, issued a press release that they might have to reinstate previous financial statements. If PLUG management knew about the problems before March 2, they wouldn't have published Q4 results on February 25.
In an 8-K filing, PLUG stressed that it only received information about the material errors only after it announced its results on January 21, 2021:
On February 24, 2021, the Company and the Audit Committee discussed those results with KPMG, and at that time, no material issues were raised. However, after the company reported its 2020 fourth quarter and year-end results, and in the course of finalizing the audit, the Company and KPMG identified the restatement items cited above. The company has since reevaluated its accounting and determined that it needed to correct the previous accounting for those items.
It isn't easy to assess the outcome of any legal trial given the many variables, including the lawyers' skills, the Judge's final decision, and obviously the facts of the case. Statistically, data from Harvard and Sandford show that about half of all securities class action lawsuits between 2009 – 2018 were dismissed.
If PLUG settles, the settlement's size will depend on loss, measured by the depreciation of shares since March 1, 2021, and the number of plaintiffs. The average PLUG share price between November 9, 2020, and March 1, 2021, is $43, compared to an average of $40 since then. Not all shareholders witnessed loss. PLUG shares are up 4% YTD and up 90% since November 9, 2020. None of the investors buying from November 9, 2020, until December 17, 2021, lost money. This group constitutes 33% of the trading volumes of the class action suit's plaintiffs.
Having said that, PLUG is not out of the woods on the class action lawsuit front. Investors bought at record highs between $47 and $73 per share with an average of $60 per share, putting a market cap for PLUG at 35 billion. Still, given the company's cash position and the statistical probability of the case being dismissed, I believe this issue is manageable.
Reclassification of R&D Expenses
One of the main issues raised in the company's communique was the restatement of some R&D costs back to COGS, which would result in squeezing gross margins. Gross margins have been an issue and a focus of analysts for quite some time. The company needed to lower the price to compete with traditional lead batteries, and gross margins have been an issue for a long time. A closer look at the figures reveals that R&D expenditures are small. Even taking an extreme case where all the Company's R&D expenses are reversed back to COGS wouldn't materially affect the company.
FY 2020 | FY 2019 | FY 2018 | |
Net Revenue | $ (316,341,000) | $ 230,239,000 | $ 174,632,000 |
COGS | $ 216,557,000 | $ 202,273,000 | $ 172,010,000 |
Gross profit | $ (423,343,000) | $ 27,966,000 | $ 2,622,000 |
R&D | $ 32,133,000 | $ 33,675,000 | $ 33,907,000 |
Source: Company financial statements
It also should be noted that Revenues include discounts from vested stock warrants. Gross revenues are a bit higher, as shown below.
FY 2020 | FY 2019 | FY 2018 | |
Net Revenue | $ 337,000,000 | $ 236,800,000 | $184,800,000 |
COGS | $ 322,874,000 | $ 202,273,000 | $ 172,010,000 |
Gross Profit | $ 14,126,000 | $ 34,527,000 | $ 12,790,000 |
R&D | $ 51,018,000 | $ 33,675,000 | $ 33,907,000 |
Source: Company financial statements.
Currently, the company is making huge discounts on its products to gain afoot to the door for its customers. For example, in FY 2020, the company lost $40 million on its GenKey, which includes aftermarket service and integration solutions.
Adjustments to Right of Use Assets and Finance Lease Obligations
PLUS sells fuel cells, and hydrogen infrastructure products, and installation services. At this stage of the industry life cycle, PLUG customers have the upper hand in negotiating sales deals, and it happens that many PLUG customers wish to rent PLUG's products rather than buy them. Since PLUG needs cash but cannot finance all its customers, its management came up with a creative solution that entails PLUG selling its product to Wells Fargo for money and then rent it back before leasing it to its customers. The Wells Fargo side of the equation is called sale/leaseback, a financial engineering concept, and where PLUG is a lessee. The customer side of the equation is financial/operating lease, where PLUG is the lessor. In addition to being a lessee and a lessor for the same asset, sale/leaseback and finance leasing includes estimates and subjective judgments on valuations, including but not limited to present values and discount rates.
The company announced that it intends to lower the Right of Use Assets' carrying value, reflecting the leaseback contract's value to Wells Fargo. The company also will adjust the finance lease for some of its customers. The end result is a smaller book value per share. This is generally an adverse event, but show me an investor investing in PLUG for its assets' book value. PLUG is a growth stock, and its value is derived from its position in a growing industry. This is why management stressed that the adjustments don't affect the cash position or future sales and is why all except one analyst maintained their ratings.
Summary
PLUG uses complex accounting methods that reflect its operations' complexity, including sale/leasebacks, valuation of ROUs, and financing leases. Still, none of these hurt the core investing thesis of PLUG, which depends on growth to achieve the economics of scale necessary for improving its margins. I acknowledge that the reclassification of some R&D expenses as COGS will have a negligible impact on gross margins. Still, investors can't ignore that the company is moving in the right direction, as demonstrated by the number of units sold increasing in 2020, despite the challenging environment.
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