Tales from the Short Side
Company X is consumer electronics company that has a razor/blades model where they sell you a piece of hardware that allows you to connect with their internet service. They include a year of service in the selling price and then seek to sign you up for long-term contracts on their service. They also sell related add-on packages. Since Company X’s management has a history of aggressive behavior, fairly deep pockets, and has demonstrated a willingness to engage in frivolous lawsuits to get what they want, they shall remain nameless.
Because their services are paid for in typical contract terms of one to three years, they take in a lot of cash as the business is growing. Since the product is not delivered when the cash is received, this gets booked as deferred revenue on the balance sheet. Since the business is relatively new, the deferred revenue growth has been impressive.
To value this company, you would want to know three things:
how many customers are going to buy the product
how long the customer will use the service once they’ve bought the product
how much it will cost to deliver product and the service over the expected customer life
The company’s filings provide very little help in that regard. The income statement is riddled with one off gains from a whole host of activities, including speculative bets on the company’s stock. There are no comments about unit sales of the product. Customer churn numbers are not mentioned at all. The only figure you can glean from any of the company filings are total cumulative product sales rounded to the nearest million. By my estimates they sell around 1.5mm units/year, so that level of rounding is not very helpful quarter to quarter.
Since management claims their product is revolutionary, you would expect the customers to be ecstatic about it. Looking at the subscription revenues, it appears that the retention rate of customers is around 33%. So 2 out of 3 customers leave the service every year. Not very impressive when you consider that just buying the product locks you in for a year. Given that some of these customers have signed multi-year contracts, that retention rate is abysmally low. It’s the kind of retention rate that would suggest that the service is not at all revolutionary.
Consider the sales growth of SolarWinds (SWI), a tech company that does enterprise infrastructure management software. The company has made some acquisitions, but the trend is reminiscent of a company that is changing the way its customers conduct their business.
Now consider Company X’s product sales figures over the last few years.
If you start hunting around for an explanation for the poor customer acceptance, you quickly stumble across a whole host of review sites that grumble about poor customer service, bad billing practices, and trouble with the technology itself. A number of the positive reviews you read appear to be fake; either left by anonymous users or using similar phrasing to the press releases put out by the company.
That of course, doesn’t make this a good short. Shitty products can exist for a long time. And most managements believe their products walk on water regardless of how good they really are.
What makes this a good short is the fact that this company has been piling up cash for several years now and have amassed a good cash hoard that should now be used to provide service to this declining user base. The service should be reliable, and they should be making sure that as sales dwindle, the customers they do have stay with them as long as possible and provide an annuity business. At the very least they should make sure they have enough cash on hand to provide the service the customers have signed up for.
Instead they are taking that cash and putting it into the stock market. Over the last few years cash and investments have fluctuated between $25 and $50mm, and at any given time more than half of that has been invested in a mix of equities, derivatives, and investment funds, as well as stocks that they have sold short. In fact, this investment scheme was so complicated that the CEO charged the company an advisory fee of over a million dollars one year. Also, judging by the returns on this investment, the holdings are highly volatile.
Company X began buying back shares on a massive scale this past year and has continued into 2012. And the CEO has been selling.
At some point, the company will need cash to create the next product, or to keep the lights on. And it won’t be there.
That is why this is a good short.
