Tuesday, March 29, 2011

Short-sale Saga

Below are the Weekly Comments from Crystal Equity Research on EBIX published March 28, 2011.  We were not able to duplicate all of the tables provided in the article on which our comments are based.  We suggest readers used the links provided to visit the article and see the tables as they were originally presented.


Shares of Ebix, Inc. (EBIX:  Nasdaq) dropped sharply in trading near the end of last week following publication of a weblog article on the financial information portal Seeking Alpha.  The article was written by an individual writing under the alias “Copperfield Research” and disclosing an existing short-position in EBIX.  The prospect of a tit-for-tat exchange between Ebix management and a short-seller along with the class action lawsuits that often accompany green-mail and short-and-distort schemes, we are changing our rating to hold in EBIX.  Investors unwilling to wait out the storm for a return to normal trading should take profits and exit the stock during any period of strong trading volume.

The author of the blog article in question disclosed an existing short-position in EBIX and claimed it was necessary to hide his true identity to protect himself from corporate retaliation.  While the credibility of financial research published under an alias and the willingness of the Seeking Alpha organization to be used in a potential short-and-distort scheme are worth discussing, we will leave these two topics for another time.  Today we look at each of the points included in the three-part article posted by this party to the Seeking Alpha on-line platform.  Our comments are not intended to lay out our own bull case investment thesis for EBIX, but to simply review the logic and validity of the short-seller’s argument.

The review of the article was challenging as the promise of a bear case was laced with inflammatory, doomsday language.  Thus we decided to reprint the entire post and add our commentary in parenthesis, and in bold and underlined font to make it easier for investors to track both the short-seller’s argument as well as our commentary on the main points.  We highlighted in red font the author’s language which we regarded as provocative for the purpose of frightening investors with a long-position in EBIX and not informative for the purpose of explaining or proving the short-sale thesis.

While there were important points made in the following paragraphs, the sum total does not appear to support the characterization of Ebix as a “house of cards” as charged by the article’s author.  The author brought up important areas of concern but made comments apparently intended to frighten an investor or trigger personal animus rather than drill down to the real financial risk.  Instead, the article is a lengthy diatribe laced with personal accusations against the CEO and filled with lots of calculations that appear to reveal out of-normal financial performance even if irrelevant to the question at hand or a comparison of apples to oranges.

However, we credit the author with having accomplished with some skill the goal of driving the stock down to fulfill the goal of his/her own position  -  a previously established short-sale of EBIX.    It took two days to look up and verify or refute each of the claims made by this author yet the stock sold off by more than 20% within a couple of hours after the article appeared on-line.  Clearly, those who saw the article on the day it was published did not take the time to look past the inflammatory language to make a discriminating decision.     


Below is the entire article posted by the short-seller author.  The words highlighted in red are the parts of the original article we found inflammatory and not fully supported with analysis or documentation.  (The words contained in parenthesis, underlined and in bold font are our added comments.)



EBIX:  Not a Chinese Fraud, but a House of Cards Nonetheless

Winston Churchill's famous quote, "a riddle wrapped in a mystery inside an enigma," might as well have been targeting Ebix Inc. (EBIX). EBIX has been an aggressive acquirer of a variety of companies over the years, many of which focus on the insurance industry. The company's offering mix is a confusing amalgamation of niche products that all have a "roll-up" stench. There is little effort to integrate the disparate operations and management often remains in place relatively autonomous.  (The term “roll up” has typically been used to describe the accumulation of similar business operating in different geographies.  Accumulation of car dealerships into a single parent is an example.  However, Ebix has acquired a series of companies that have widely different, but complementary product and service offerings.  These are being integrated together to product a unique business model.  The approach is quite similar to that used by Cisco Systems to address a rapidly changing and evolving communications and networking market.) 

Robin Raina, EBIX's CEO, has liberally described his business with the buzz words du jour, such as "exchanges," "CRM," "The Cloud," and "SaaS." (These terms are commonly used in the networking and communications industry to described Internet product or service deliver platforms or web-based applications.  The acronym CRM has been commonly used for years for Customer Relations Management.  Using such words can help investors more easily compare and contrast the Ebix business model against other companies that describe themselves with the same commonly accepted terminology.)

The stock has performed well, fueled by retail investor interest, momentum publications like Investors' Business Daily and minimal scrutiny from analysts. We believe that EBIX is nothing more than a roll-up that has materially misrepresented its business (relative to the CEO's buzz words) as well as its organic growth. Its business model is predicated on two principals: tax arbitrage and dramatic cost cuts (headcount reductions and offshoring), neither of which is sustainable. Further, the company's tax arbitrage may be more than "just" unsustainable, it may actually be illegal.  (The allegation of illegality in the reporting of taxes is not entirely supported in the subsequent sections, thus we have labeled this as inflammatory as well.)  

EBIX's problems run deeper than unusual accounting. The EBIX story also comes with multiple auditor resignations, governance abuses, misrepresented organic growth, questionable cash flow and a contentious CEO. Below we address these concerns in great detail. Given the gravity of these issues, we have notified the IRS and the SEC of the material abuses at EBIX. (That this analyst or research group has actually made a report to the IRS or SEC is not documented and so much also be construed as having been added for its shock value.)  We hope the warranted scrutiny saves investors from significant losses as the true EBIX story gets told.

EBIX shares are worth no more than $9.00, a level that would represent a 65% decline from current prices. We arrive at our target by adjusting current consensus estimates for a 35% tax rate (where it will likely go), and applying a generous market multiple of 12x normalized earnings (consensus estimates include assumptions that are unattainable and adjust for oddities such as amortization, while failing to contemplate massive underinvestment in sales and R&D). We estimate that the company has less than $0.75 of de novo earnings power.  (First, we note that the S&P 500 is currently trading at 23.8 times trailing earnings.  The EBIX peer group of business software and services providers is trading at 26.5 times trailing earnings.  Since Ebix carries lower debt levels and has reported higher profit margins than the peer group, the argument could be made to even accord EBIX a multiple above the average.  Second, the appropriate level of investment in sales and R&D is not fully identified in this article, thus the conclusion of “massive” under investment is considered inflammatory.)

(We view the introduction, the part of an article that most investors would read without continuing further, as designed to alarm and misdirect rather than inform. 

The next section relates primarily to the article’s organization.  We offer our commentary in the expanded section rather than in this preliminary section. )

Part I of this his report will detail:

1) The History of a Roll-up & Its "Slash & Burn" Strategy. The $970 million of "value creation" imbedded in EBIX's valuation is likely to collapse given the myriad of issues the company currently faces.

2) EBIX's Atrocious Organic Growth and Manipulative Metrics. Investors have a distorted view of the company's growth profile. We estimate organic growth was negative in 2009 and was less than 4% in 2010. Management's definition of organic growth is highly manipulative and demonstrates the deceptive nature of the CEO.

3) Growth Crippled by Suspiciously Low Sales and R&D Expense. EBIX's extremely low sales and marketing and product development expenses are not consistent with a technology company. EBIX's company-wide sales and marketing expense was $2 million less than the stand alone run-rate of a recent acquisition. This acquired company that outspent EBIX was 1/20th of EBIX's size. EBIX's margins are overstated and will be crippled by massive reinvestment to avoid larger declines in organic growth. The only segment of EBIX's business that has not benefited from a recent acquisition declined 27% in the fourth quarter.

4) ADAM Assumptions are Incomprehensible and EBIX recently closed its largest acquisition to date. EBIX must improve ADAM's margins by 2,500 basis points on day one, grow faster than ADAM did in the previous 3 years, recognize no D&A expenses and recognize a zero percent tax rate to generate the $0.15 of accretion that the company has guided to. This overly aggressive guidance will result in negative earnings revisions relative to analyst's elevated expectations.
Will Drive
Disappointment in 2011.

Part II of this his report will detail:

5) Potentially Illegal Tax Strategy and Impact on Earnings and Valuation.

EBIX utilizes two strategies to reduce taxes to nearly zero. The first strategy suggests a lack of oversight from auditors and earnings manipulation. The second is more sinister and potentially illegal. Through a series of superficial transactions that pose no business purpose other than to avoid U.S. taxes, EBIX was able to turn each dollar of foreign revenue into $1.40 of profits in 2010. This tax strategy is not sustainable in the near, or intermediate, term. A higher tax rate in the future will dramatically change the economics of EBIX's business, significantly impair its earnings expectations, and could subject the company to significant fines, penalties and back taxes.

6) Free Cash Flow Myth. Many investors use free cash flow to justify EBIX's valuation. We believe EBIX's free cash flow is a highly distorted metric given limited cash R&D expense and its questionable tax strategy. In fact, if investors simply adjust for a normalized tax rate, then EBIX trades at 37x free cash flow. Taken a step further, and adjusting for R&D expense for acquired technology costs (acquisitions in the cash flow from investing segment), then EBIX trades at nearly 50x free cash.

7) Significant Quality of Earnings Issues. EBIX appears to manage earnings through accounting shenanigans, including accounts receivable and its allowance for doubtful accounts. The very low level of acquisition price allocated to non-indefinite intangibles is highly suspicious for a technology company and points to a lack of auditor oversight and a desire to overstate earnings through lower amortization. In 2010, EBIX generated almost $0.20 of earnings that are unlikely to repeat in 2011, which could drive incremental earnings disappointment.

Part III of this his report will detail:

8) History of Auditor Turnover, Shockingly Low Audit Fees and Accounting Red Flags. Investors should view EBIX's stated financials with extreme skepticism given the myriad accounting and oversight issues. EBIX has had four different auditors over the past seven years. Management's explanation for the high auditor turnover does not reconcile with the company's filings. EBIX pays its tiny regional auditing firm less than $350,000 a year in audit fees, a tiny fraction of the audit fees that are paid by companies EBIX's size.

9) Controversial CEO Appears to Demonstrate a History of Misrepresentation. EBIX's CEO does not allow analysts or investors access to other members of his management team. This alone is cause for concern about what Robin is hiding. The CEO makes 1,250% more than any other employee. The company's lack of bench strength will again be on full display at their second ever analyst day on April 1st. The CEO's charity appears to make outlandish claims relative to its size and scope.

10) SaaS Provider? We Think Not. EBIX's management and analysts claim EBIX is the next great SaaS provider. This is a gross misrepresentation. SaaS companies measure their deferred revenue in quarters and years due to the subscription nature of the business. EBIX's deferred revenue can barely be measured in days and weeks. As a result, EBIX has minimal visibility relative to real SaaS providers. Also, management misrepresents its products by classifying the majority of its business as "exchanges." These misrepresentations are consistent with management's historical actions.


(Our commentary on the author’s principal points begin here.)

1) The EBIX Roll-up & Its "Slash & Burn" Strategy
EBIX current business has been cobbled together from 18 acquisitions, spanning the past seven years. Prior to this acquisition spree, EBIX had no growth, less than $15 million in revenue, and at times in 2003 traded with a NEGATIVE enterprise value ($6.2 million market cap with $6.8 million of cash). Today, the company's controversial CEO has pulled off one of the most unique acquisition arbitrages in history. He has turned $276 million of acquisitions (Table 1) and very little starting enterprise value into a company with $1.2 billion of enterprise value. The $970 million of "value creation" imbedded in EBIX's valuation is likely to collapse given the myriad of issues the company currently faces.  (The “myriad of issues” are not fully identified here or elsewhere.  Strategic acquisition strategies are not uncommon for companies with products and services dependent upon technology innovation.  The average of approximately two to three deals per year is not unusual.  Thus we label this as more inflammatory language.)

Table 1 - Acquisition History vs. Current Enterprise Value









Estimated









Date
Price







1
Lifelink
2/04
10,500







2
Heart Consulting
7/04
7,000







3
Infinity Systems
5/06
7,400







4
Finetre
10/06
13,000







5
IDS Jenquist
11/07
12,250







6
Telstra eBusiness
1/08
44,000







7
Periculum
4/08
1,300







8
Acclamation
8/08
22,000







9
ConfirmNet Corporation
11/08
10,460







10
Facts Services
5/09
6,500







11
Peak Performance
10/09
9,500







12
E-Z Data
10/09
50,400







13
MCN Technology
1/10
2,900







14
Trades Monitor
4/10
2,750

EBIX





15
Connective Technologies
5/10
1,300

Diluted shares
42,068




16
E-Trek
7/10
1,000

Diluted market cap
1,238,903




17
USIX
9/10
7,600

Cash
29,697




18
ADAM Inc.
2/11
66,000

Debt
35,575

Difference



Total

275,860

Enterprise value
1,244,781

968,921



Source: Company filings and estimates








The economics of the company's acquisition strategy is relatively simple: tax arbitrage (described later) and dramatic cost cuts (headcount reductions and offshoring to India). An example of this is the acquisition of E-Z Data in October 2009. A San Gabriel Valley Tribune story highlighted how EBIX fired 49 of the company's roughly 100 employees within a week of that acquisition. One former E-Z Data employee remarked: "it was a wonderful family organization, but this is just a slash and burn."  (Reduction in duplicative functions such as human resources, accounting and other administrative personnel is expected following an acquisition.  Most investors applaud cost cutting as a means to achieve higher profit margins under any circumstance.  The news article cited was published in a local paper and appeared to focus on the human side of business transactions.  We view this point as weak.)

Synergies are okay. Calling inorganic growth organic is not. This strategy has avoided criticism and scrutiny by Wall Street analysts, a fact that will likely change when EBIX begins missing numbers.

2) EBIX's Phantom Organic Growth and Mysterious Metrics
Investors have a distorted view of the company's organic growth profile (historically roll-ups trade at low earnings multiples). This confusion exists because the company stopped disclosing revenue from acquisitions in the fourth quarter 2008. EBIX previously provided revenue contributions from each acquisition. The following was the disclosure from the BPO segment in the 2008 10-K :
BPO division revenues increased $7.1 million which includes revenue increases of approximately $5.5 million from EbixBPO’s-Hemet, CA operations (formerly IDS; acquired in November 2007), $596 thousand from the EbixBPO’s-Portland, MI operations (formerly Periculum; acquired in April 2008), and $1.1 million from EbixBPO’s-San Diego, CA operations (formerly ConfirmNet; acquired in November 2008).
This disclosure allowed investors to calculate organic growth, a critical disclosure for a roll-up strategy. With the collapse in organic growth in 2009, the company has ceased providing these disclosures.

EBIX has also stopped disclosing the impact of foreign exchange on revenue in the fourth quarter of 2009. This happened to be the same quarter that foreign exchange became a tailwind to growth. The pattern of selective disclosures does not stop there.  (Foreign exchange gains are disclosed in the 2010 10K in the income statement and in footnotes on page 23.  Foreign exchange exposure is also discussed in the risk factors and in footnotes on market risk and hedging activity that describe the amount of Ebix sales denominated in U.S. dollars and company’s exposure to the Indian rupee.  The 2010 10K made the foreign currency situation fairly clear with the following from Item 7A:

“During the years of 2010, 2009, and 2008 the net change in the cumulative foreign currency translation account, which is a component of stockholders’ equity, was an unrealized gain (loss) of $6.5 million, $11.5 million, and $(15.1) million, respectively. The Company considered the historical trends in currency exchange rates and determined that it was reasonably possible that adverse changes in our respective foreign currency exchange rates of 20% could possibly be experienced in the near term future. Such an adverse change in currency exchange rates would have resulted in reduction to pre-tax income of approximately $3.5 million, $2.6 million and $2.9 million for the years ended December 31, 2010, 2009 and 2008, respectively.”   

Italics added to differentiate the excerpt from the 10K and our commentary.)

Management set its organic growth goal of 10% to 15% for 2010. On its fourth quarter 2010 conference call, management stated that the company's organic growth was 11% in 2010. We believe the company lied. EBIX had organic growth that was significantly below this figure. Instead of confessing, management appears to have "redefined" organic growth to include acquisitions. If management is willing to manipulate the metrics around growth, what else might management be manipulating?

Our analysis suggests that EBIX management is actually recognizing the benefit of a target's growth BEFORE they were acquired by EBIX. Below is the company's calculation of organic growth from the 2010 10-k .  (Table 2 provided below is labeled by the author as Ebix’s calculation of organic growth.  The data is taken from the Ebix 10K but Ebix did not offer the data as a calculation of organic growth.  It is normal practice to report historic results pro forma as if an acquisition had taken place at the beginning of the fiscal year in which the deal was consummated.  This practice is followed by all companies reporting acquisitions deemed material to the acquirer and is not unique to Ebix.  This is an example of how this author makes a charge of deception by mischaracterizing materials taken out of context from Ebix’s SEC filings.)

Table 2 - EBIX's Calculation of Organic Growth


As Reported
Pro Forma

As Reported
Pro Forma

2010
2010

2009
2009
Revenue
132,188
139,047

97,685
125,612
Net income
59,019
59,635

38,822
38,032
Basis EPS
1.69
1.71

1.24
1.69
Diluted EPS
1.51
1.52

1.03
1.01
Source: company filings






Below we diagram a hypothetical example of a company growing at 1%, acquires a company that, previous to the acquisition, was growing at 50%. According to EBIX's math, this 1% grower had a 24% "organic" growth rate in 2010. Conversely, if the same target's revenue declined 50% year over year, this 1% grower would have had a -27% organic growth rate under EBIX's distorted metric. It is clear from this example how irrelevant EBIX's "definition" of growth has become and that management is trying to hide a collapsing organic growth profile.  (The example of a hypothetical company using the short-sellers version of how he/she believes Ebix is measuring organic growth is misleading.  What is relevant is what Ebix actually reports and where that revenue came from.)

Table 3 - Illustration


Acquirer
2009
2010
Revenue
$ 10.0
$ 10.1
organic growth

1%
Scenario I - Target - $6mm revenue 50% through 2010
Acquired Rev

$ 3.0
Total revenue
$ 10.0
$ 13.1
Reported revenue growth

31%
Target's grew 50% in 2010


Acquired Rev
$ 3.0
$ 6.0
Pro Forma Rev under EBIX's method
$ 13.0
$ 16.1
Organic growth under EBIX's method

24%
Scenario II


Target's declined 50% in 2010


Acquired Rev
$ 12.0
$ 6.0
Pro Forma Rev under EBIX's method
$ 22.0
$ 16.1
Organic growth under EBIX's method

-27%


The REAL organic growth over the past two years appears to be relatively minimal. We caution that this is only an estimate as the company no longer provides enough disclosure, but estimating the contributions of acquired businesses leads to the conclusion that EBIX has no growth. Additionally, foreign exchange was a large benefit to growth given the weakness in the dollar over the past two years. As stated above, management stopped disclosing this impact. (As noted above the foreign exchange disclosure in the 2010 10K was very clear.) As a result, our organic growth estimates are likely too high. Table 4 suggests organic growth that was negative in 2009 and only 4% in 2010, FAR BELOW management's goal and insinuations.  (By the strict definition of organic growth, the Periculum, Acclamation and ConfirmNet deals completed in 2008 should be considered existing or established operations in 2009 and the Peak and E-Z Data acquisitions completed in October 2009  should be included in existing operations at the beginning of 2010.  Thus the calculation of revenue from acquisitions using the data from the table below should be $10.4 million in 2009 and $5.0 million in 2010.  However, the author has inflated the calculation of revenue from acquired operations by counting deals completed in the previous year.  This approach might be acceptable for deals completed very near the end of the year such as ConfirmNet in November 2008 and perhaps even Peak and E-Z Data in October 2009.  Such definitions are key to the calculations and the arguments made either in support of a bull case or a bear case.  For example, excluding Periculum and Acclamation, we estimate using the short-sellers figures that acquired revenue was $15.8 million, implying organic growth was 9.6%, well above the short-seller author’s claim that organic growth was negative in 2009.)

(Revenue and earnings contributions from acquired operations are customarily disclosed in financial filings when those figures are material to the existing operation.   The figures used in Table 4 below were not published by Ebix or the acquired operations in public filings.  The figures are estimates of the short-seller author and cannot be verified without further disclosure from the author.)

“The attention to organic growth paid by the short-seller author is valid.  However, the author misses the opportunity to point out what could be a greater problem for Ebix  -  the potential failure to fully integrate the acquired operations and create a portfolio effect with the combined product and service portfolio.  Such an analysis would take considerable time and trouble to lay out compared to the few calculations presented here and insinuations that management is somehow hiding something.” 


Tablx 4 - EBIX Estimated Organic Growth




Close







Date
2009
1Q10
2Q10
3Q10
4Q10
2010
Total Revenue

97.7
31.6
32.2
33.3
35.1
132.2
Acquisitions







IDS Jenquist
11/07






Telstra
1/08






Periculum
4/08
0.3





Acclamation
8/08
6.9





ConfirmNet
11/08
5.5





Facts
5/09
2.3
0.7



0.7
Peak
10/09
1.8
1.8
1.8
1.8

5.3
E-Z Data
10/09
6.3
7.0
6.5
6.3

19.8
MCN
1/10

0.4
0.4
0.4
0.4
1.5
Trades Monitor
4/10


0.3
0.4
0.4
1.1
Connective
5/10


0.1
0.4
0.4
0.9
E-Trek
7/10



0.2
0.2
0.3
USIX
9/10



0.2
1.0
1.2








E. rev from acq

23.0
9.8
9.0
9.5
2.3
30.6
E. organic rev

74.7
21.8
23.2
23.8
32.8
101.6
E. organic rev gr

0%
6%
3%
2%
5%
4%
Source: Estimates based on public disclosure.



EBIX stopped disclosing acquired revenue in 4Q08.





3) Growth Crippled by Suspiciously Low Sales and R&D Expense
The atrocious growth profile is not surprising given the cost cutting strategy. EBIX spent $6.4 million on sales and marketing in 2010, or less than 5% of revenue. As we discuss below, this absolute spend was less than ADAM's stand-alone sales and marketing expense. ADAM was 1/20th the size of EBIX. We believe this level of sales and marketing expense is SEVEN to TEN times lower than many of EBIX's comps as a percent of revenue (Table 19 below).  

In addition, the company only spent $13.6 million on product development (10% of sales) and less than $2 million on capex in 2010. Product development costs of 10% are more consistent with companies in mature industries like industrials, not in fast growth markets as EBIX would have investors believe. As a result, EBIX's margins are overstated and will be crippled by massive reinvestment to avoid larger declines in organic growth.

(Total year-over-year sales growth was 31% and 35.3% in 2009 and 2010, respectively.  The majority of the growth can be attributed to acquisitions, which is not necessarily “atrocious.”  We regard the use of the term “atrocious” as inflammatory and not informative.

In sectors such as business software that are populated by numerous technology developers strategies to acquire technology or products are often more economical that internal development.  The argument can be made that this is a more astute investment strategy since the company is gaining technologies and products that have already been proven marketable and therefore Ebix does not have to assume that risk.  Inadequate leadership or capital often cause early stage developers to seek affiliation with larger more established operations.  They put their technologies up for sale at compelling values to seal a deal with an established player, often seeking those that can offer equity ownership in a publicly traded company. Such a strategy worked well for highly successful technology companies such as Motorola, IBM and Cisco Systems during their early stages.   

Ebix has made significant investments in technology and new products through its acquisition strategy.  Companies like Ebix that opt to acquire existing technologies rather than innovate internally will have a lower-than-average R&D or product development budget.  However, it would be premature to conclude that its margins are overstated, that Ebix is somehow behind the curve on technology investment and will be crippled by massive reinvestment in the future.  The insurance industry is among the last to adopt Internet-based sales, marketing and customer services functions.  It is a rapid evolving marketplace that presents high risk at the product development stage.  Acquiring proven products rather than making a mistake at the bench is an astute strategy.

Capital expenditures on property, plant and equipment is typically low in software oriented companies like Ebix.  PP&E is typically computer and network related, which afford significant leverage over time. 

We regard the foregoing as an apples to oranges comparison that is not valid.


4) ADAM Assumptions are Incomprehensible and
Will Drive
Disappointment in 2011
In August 2010, EBIX announced the acquisition of ADAM Inc, its largest acquisition to date. This acquisition closed in February 2011. Like most roll-ups, the music stops as the acquisitions become too large. It appears this may be the case with ADAM.

Management outlined aggressive assumptions to justify the ADAM acquisition. Management expects ADAM to be $0.15 accretive in its first year. It is our understanding that this assumption requires minimal growth of ADAM's revenues. ADAM represents the first public company that EBIX has acquired, which allows us to scrutinize the company's assumptions for the first time. According to ADAM's SEC filings, it generated $27.8 million of revenue (down year-over-year) and a 15.1% operating margin during the trailing twelve months ending September 30, 2010 (last data available).

Table 5 - ADAM's Income Statement




12/31/09
3/31/10
6/30/10
9/30/10
LTM
Revenue
7,429
6,722
6,728
6,898
27,777
YoY growth
0.3%
0.8%
-4.9%
-1.3%
-1.3%
Operating income
332
1,121
1,108
1,634
4,195
Operating margin
4.5%
16.7%
16.5%
23.7%
15.1%
Source: company filings






In reviewing two earnings models for EBIX from November 2010 (before ADAM assumptions were added), we estimate that to generate $0.15 of accretion, ADAM must generate around $11.5 million in net income to offset 3.6 million shares issued to ADAM shareholders (see Table 6).  (The calculation that follows assumes the $0.15 is to be realized within the year 2011.  Ebix management indicated the accretive period would be the twelve months beginning February 2011, thus they are expected approximately $0.13 in the year 2011.)


Table 6 - ADAM Accretion Calculation



Northland
Singular
2011 Revenue assumption pre ADAM
143,716
150,278
Net income pre ADAM
52,802
55,152
Diluted shares
39,383
39,275
2011 EPS Estimate Pre-deal
$1.34
$1.40
New shares issued to ADAM
3,651

New pro forma diluted shares
43,034
42,926
Total net income needed to add 15c per share
64,152
66,718
Assumed ADAM net income
11,350
11,566
Source: Reuters and estimates




To generate that type of income, ADAM must grow revenues by roughly 4% (the fastest growth in over three years), improve its operating margin by 2,500 basis points on day one to 40%, have no D&A costs (more of this later), and recognize a zero percent tax rate. These assumptions appear outlandish and make us wonder what is really driving the financial expectations. ADAM already had a 24% operating margin in the last reported quarter before the acquisition. This overly aggressive guidance will result in negative earnings revisions relative to analyst's elevated expectations.

(This represents one scenario.  Assuming a higher growth rate based on expectations for synergy between A.D.A.M. with Ebix existing operations would imply better coverage of fixed costs and therefore higher margins.)


Table 7 - ADAM's Aggressive Assumptions


2011


LTM
Growth
2011

Actual
Assumption
Estimates
Revenue
27,777
4%
28,888
Operating income
4,195

11,555
Operating margin
15.1%

40.0%
D&A


0
Amortization of software development
0
Stock-based compensation
0
Amortization of purchased intangibles
0
Pretax


11,555
Tax rate


0.0%
Aftertax contribution

11,555
Accretion to EBIX

$0.15


It will be very difficult for EBIX to "slash and burn" ADAM's expenses and still maintain franchise value and current revenue levels. ADAM was an efficiently run business that generated a 16.5% median operating margin over the previous five years. The Bynergy sales cycle was lengthy and required an educated and dedicated sales force. ADAM employed 36 sales people and spent nearly $8 million a year in sales and marketing expense. EBIX, on the other hand, employs only 72 sales people across the entire company and only spent $6 million in sales and marketing in 2010.

It is worth noting that EBIX had over 20x the enterprise value of ADAM prior to the acquisition (and $2 million less in sales and marketing). We believe ADAM's Bynergy business could collapse without the support of a dedicated sales force. As management discussed in the past, its 3rd party indirect channel of insurance brokers had been largely ineffective - a fact EBIX will not be able to change. We believe the company's sell side analysts have provided minimal scrutiny on these assumptions (unfortunately a recurring theme).

(The author has brought up a valid topic, i.e. the impact of a material acquisition.  However, he/she fritters it away on shallow analysis and the use of accusations to make motivate shareholders to sell rather than build a strong bear case.  The better question is whether Ebix can find enough savings to off-set incremental amortization expense and new shares outstanding arising from the deal terms.  Ebix indicated that approximately $16.4 million in tangible assets and $14.7 million in liabilities at the end of September 2010, suggesting that the deal created significant goodwill and intangibles under purchase accounting treatment.  The deal could have created significant new intangibles only a portion of which could be written-off in the first quarter 2011 when the deal was completed.  Assuming $20.0 million is within the ballpark and an average ten year life is appropriate, we estimate the incremental amortization from the deal could be as much as $2.0 million per year. 

The next element of the question is whether Ebix can save on other operating expenses to offset the incremental amortization expense, whatever that calculation turns out to be.

It would not be necessary to gut A.D.A.M.’s sales organization to achieve savings at the operating level.  Duplicative administrative and financial functions rather than sales personnel are typically the first sources of savings when combining two operations.  A.D.A.M. was also probably incurring approximately $1.0 million per year in costs associated with its status as a public company.  It would not be unreasonable to expect a savings between $1.5 million to $2.0 million in the first year by eliminating these duplicative expenses.  That said, A.D.A.M. has not been growing and a new dynamic in the dedicated sales force for Bynergy might be advisable even if Ebix’s third-party channel is not the answer.

The accounting treatment for the A.D.A.M. deal will not be completed until the March 2011 quarter is reported.)


Below is Part II of our EBIX report. Please also see part one.

5) Potentially Illegal Tax Strategy and Impact on Earnings and Valuation
The most disturbing assumption we used in the ADAM accretion assumptions is the zero percent tax rate. EBIX has been a profitable company for 10 years and acquired another company that was profitable. Both companies generate a majority of their revenue in the United States (75% for EBIX and 100% for ADAM). How could it be possible that EBIX will not pay income taxes in the United States? In researching the topic, we found a disturbing explanation which, if changed, could dramatically alter the economics of EBIX's business, significantly impair its earnings expectations, and possibly subject the company to significant fines, penalties and back taxes.

Further, we believe aspects of EBIX's tax provision do not conform to GAAP and could result in a restatement (if the company had an auditor with the resources to scrutinize this accounting treatment). Since 2002, EBIX has provisioned $5 million in GAAP taxes in total, despite being profitable from a GAAP perspective each quarter. We find this discrepancy alarming. Below we highlight some prominent U.S. technology companies with meaningful international operations and their most recent tax rates.

Table 8 - Tax Rates



2009
2010
EBIX
3%
1%



salesforce.com
40%
41%
IBM (IBM)
26%
25%
Apple (AAPL)
32%
24%
Google (GOOG)
22%
21%
Microsoft (MSFT)
26%
25%
Source: company filings



EBIX utilizes two strategies to reduce their taxes. The first is the utilization of an NOL and a valuation allowance against their deferred tax asset. A valuation allowance against a deferred tax asset is used when a company is unprofitable and the deferred tax asset may not be used in the future. Until December 31, 2009, the company maintained a full valuation allowance against their deferred tax asset. This implied that they would never generate enough profits in the future to utilize the NOL.

This allowed the company to maintain a zero percent GAAP tax rate, as taxable income was reduced by the release of the valuation allowance. In its 2009 10-k, management justified the valuation allowance "due to uncertainties related to the potential adverse impact to our health benefits exchange operating segment associated with recently passed health care legislation."

For a company that had been profitable for 32 straight quarters with 35% "reported" operating margins for 13 straight quarters, this was an absurd argument. At December 31, 2010, EBIX maintained a $6.6 million valuation allowance (all tied to acquired businesses) after releasing $2.3 million in the fourth quarter 2010. We believe that the valuation allowance should have been reversed years ago and this accounting treatment suggests a lack of oversight from auditors and possible earnings manipulation.

The second strategy to reduce the tax obligation: EBIX utilizes a controversial transfer tax strategy to shift U.S. income to India and Singapore. Singapore represents just 3% of their revenue, 27 employees, and only $271,000 of fixed assets. The only meaningful asset is $135 million of goodwill and intangible assets (58% of total). In India, they generate no revenue, have only $3.1 million of fixed assets, and 530 employees (45% of total).

Table 9 - 2010 Geographic Mix






North America
Australia
New Zealand
India
Singapore
Total
Revenue
99,299
27,253
1,480
0
4,156
132,188
Fixed assets
3,646
688
40
3,161
271
7,806
Goodwill and intangible assets
98,190
545
0
0
134,993
233,728
Employees
533
77
12
530
27
1,179
Source: 2010 10-k








Despite generating 75% of revenue in the United States from mainly U.S.-domiciled companies, and minimal revenue from India and Singapore, EBIX has tried (successfully to date) to utilize a questionable loophole to reduce its tax obligation. Through a transfer tax mechanism, EBIX has shifted most of its U.S. income to its foreign operations. Through a series of transactions, EBIX transferred their "intellectual property ownership…into our Singapore and India subsidiaries." EBIX then utilizes foreign tax holidays to reduce tax obligations in these foreign operations. As table 10 suggests (from the company's 10-k), they have been successful in transferring most of their domestic revenue into foreign earnings.

Through this superficial series of transactions that pose no business purpose other than to avoid U.S. taxes, EBIX was able to generate a 140% operating margin in 2010 in its foreign operations. EBIX's foreign operation is the Rumpelstiltskin of finance, turning a $1 of revenue into $1.40 of profits. If the transactions are declared a sham, EBIX will face significant fines, penalties and back taxes. EBIX has generated almost $150 million of pretax earnings in the past five years. At a 35% tax rate, this could equate to over $51 million in back taxes prior to interest penalties or fines.

Table 10 - 10-k Income Disclosure




2007
2008
2009
2010
Domestic income before tax
12,823
7,921
14,501
13,694
Foreign income before tax
376
20,778
25,331
45,960
Total
13,199
28,699
39,832
59,654





North American revenue
31,474
48,340
73,431
99,299
Foreign revenue
11,367
26,412
24,254
32,889





Implied margin - Foreign
3%
79%
104%
140%
Source: 10-k






This aggressive tax treatment is similar to KPMG's tax shelter fraud scandal several years ago. The aggressive strategy pitched by the Big Four accounting firm resulted in a criminal conspiracy charge against KPMG and resulted in 19 indictments of criminal tax fraud, criminal conspiracy, and tax evasion. Another Big Four firm, E&Y helped EBIX concoct the current strategy. This is a strategy that any U.S. company could pursue if they had operations abroad and wanted to avoid paying taxes.   (Please, this is a ridiculous insinuation.  The four tax shelters at issue in the KPMG case were all configured by KPMG itself.  The tax shelters KPMG sold to unsuspecting clients were known as bond linked issue premium structures or BLIPS, foreign leveraged investment programs or FLIPS, offshore portfolio investment strategies or OPIS and a variant of FLIPS; and short option strategies called SOS.)

Given the precarious debt situation in the United States, the IRS and politicians are increasingly focused on companies like EBIX that enjoy all the benefits of the U.S.'s vast corporate wealth, stable regulatory environment and resources, but find loopholes to avoid or reduce taxes. This attitude was front and center in President Obama's State of the Union speech on January 25, 2011, where he said:

Over the years, a parade of lobbyists has rigged the tax code to benefit particular companies and industries. Those with accountants or lawyers to work the system can end up paying no taxes at all. But all the rest are hit with one of the highest corporate tax rates in the world. It makes no sense, and it has to change. So tonight, I'm asking Democrats and Republicans to simplify the system. Get rid of the loopholes. Level the playing field. And use the savings to lower the corporate tax rate for the first time in 25 years – without adding to our deficit.

The President might as well have been directing his comments to Robin Raina and EBIX. Following the President's comments, Republican Dave Camp, the Chairman of the House Ways  and Means Committee, proposed cutting the corporate tax rate by "reducing or eliminating tax deductions and credits." A Democratic proposal aims to "end special tax breaks favoring certain business sectors and repeal a rule that allows companies to defer taxes on income earned abroad."

To this point, buried in its 10-k, EBIX disclosed that in the fourth quarter 2010 it took a "charge to increase the Company’s reserves for uncertain tax filing positions as evaluated by management." It appears that management may be acknowledging that its current tax situation is unsustainable.

Companies with low but unsustainable tax rates have historically traded at low multiples as the market adjusts their "E" in the price to earnings calculation. An example of this is Bermuda reinsurance companies, who trade at roughly 6x earnings under the assumption that their tax free status is unlikely to continue into perpetuity. EBIX recorded a 1.1% tax rate in 2010 and analysts appear to be modeling a 10% rate in 2011. A less favorable tax situation going forward dramatically changes the earnings profile, free cash flow and valuation of the company. Adjusting EBIX 2010 operating results for a 35% tax rate reduces earnings to $0.90 per share.

(Other than the ridiculous insinuation that operating on low-tax jurisdictions is fraud, this section is on point and the short-seller has correctly picked up on the nuance of the 2010 10K disclosure.  However, the facts simply bolster the argument that Ebix net income or earnings is too noisy to provide a sound basis for valuation.  The alternative is to adjust net income to account for a fair tax rate in the future. 

That said, we do not believe that the U.S. will take action any time soon to prevent legitimate operations based in low tax jurisdictions from taking advantage of those tax-related benefits.  The near and present tax question appears to be whether the U.S. can figure out how to entice U.S. operations to repatriate income so that it can be taxed here.  A tax holiday is the measure that has been discussed so far.  We believe it would be more likely that tax haven such as Bermude where companies located their headquarters but have no operations would be a more likely target for Congressional tax reform efforts.)

6) Free Cash Flow Myth
As a serial acquirer, EBIX free cash flow is not representative unless cash costs of acquisitions are included. EBIX needs acquisitions or the house of cards collapses. Roll-ups artificially increase free cash flow as they report significantly less cash research and development costs, which are recognized as an amortization expense and a cost of acquisition. In EBIX's case, this cash flow shows up in the cash flow of investing section of the income statement, not cash flow from operations.

If EBIX had to develop these products internally, this expense would come out of operating cash flow and significantly reduce free cash flow. This is one of the reasons EBIX only spends 10% of its revenues on R&D. EBIX's questionable tax strategy also distorts this figure. We estimate that EBIX's free cash flow was $33 million in 2010 at a 35% tax rate, implying over 60% downside to get to a more normalized low-teens multiple to free cash flow. We estimate its free cash flow was $25 million adjusted for a more normalized sales and R&D expense, implying over 70% downside.  (It is an appropriate point of departure in a valuation exercise to adjust cash flow from operations for both acquisitions and a higher rate of R&D expense.  A company would carry out one or the other or an appropriate mix of the two.  There is no justification for making an adjustment for sales expense unless Ebix was going to execute on plan to change its sales and marketing strategy.  The company has elected to leverage third-party sales channels as an effective means to penetrate the market at a low cost.  There is nothing “normalized” about a higher sales and marketing budget. 

If Ebix were to change its strategies in favor of internal product development and a direct sales force.  There would be significant additional income statement changes.  Amortization of intangibles would begin declining relative to sales, reducing operating expenses.  A direct sales approach rather than negotiating terms with channel partners would allow the company to capture more value thereby boosting gross profit margins. 

The short-seller author’s focus on free-cash flow is appropriate but the modeling is faulty.)


Table 11 - EBIX 2010 Adjusted Cash Flow


CFO
52,779
Adjusted CFO for 35% tax rate
35,098
Capex
(1,754)
Adjusted FCF
33,344
Enterprise Value
1,244,781
FCF / EV multiple
37.3x


7) Significant Quality of Earnings Issues
EBIX appears to manage earnings through a number of various accounting tricks that reduces the quality of earnings. Over the past six quarters, the company's accounts receivables growth has exceeded its revenue growth by over 30% on average.

Table 12 - Accounts Receivable






9/30/09
12/31/09
3/31/10
6/30/10
9/30/10
12/31/10
Revenue growth - yoy
15.5%
55.4%
52.9%
43.6%
42.9%
12.1%
Gross A/R growth - yoy
30.4%
68.6%
63.5%
48.8%
54.4%
13.9%
Source: company filings








In the past, EBIX management has defended the problems with accounts receivable by focusing on aging. We would point out regardless of collection vintages, earnings appear to be managed through accounts receivables. As an example, in the third quarter of 2010, revenue increased only $1 million sequentially (despite the benefit of two new acquisitions and two that closed late in the second quarter). Accounts receivable increased over $4 million during that same period.
EBIX would have materially missed revenue and earnings estimates if it were not for this dramatic growth in accounts receivable and $3 million of net "cashless" revenue. Unsurprisingly, this data point received little scrutiny from the company's sell side analysts (who are all recommending the shares).

(The analysis of accounts receivable growth against sales growth is a valid means to scrutinize earnings quality.  However, all current accounts must begin reflecting the addition of acquired operations at the end the quarter in which the deal occurred.  When there are deals in the period time series analysis is less informative.  The total accounts receivable for the acquired operations will be included while only that portion of its revenue that occurred in the reporting period after the deal closed.  Thus accounts receivable growth will outpace revenue growth in that first reporting period after an acquisition.  This happens with every company that completes an acquisition and represents no evidence of subterfuge on the part of Ebix.)


EBIX has experienced significant volatility in its allowance for doubtful accounts, another tool to distort the timing and quality of earnings. Despite the unrelenting growth in accounts receivable, EBIX has just recently started to increase its allowance. (This is a weak argument.  The allowance percentage increased as the result of both a nominal increase in the allowance and a reduction in the amount of accounts receivable outstanding.  Ebix apparently stepped up collection efforts during the final months of 2010 and was 1] successful in picking up the pace of collections [lower days sales outstanding] and 2] was able to identify more accounts that could be considered doubtful.  

This is a positive development and does not support of a bear case.  The variance in doubtful accounts appears to have some relevance only because they are presented without describing the factors that are impacting the nominal figures.)

click to enlarge


Another earnings quality issue with EBIX is the large amount of goodwill and intangibles that does not flow through the income statement.  (Help!  Goodwill never flows through the income statement unless it is found to be impaired and has to be written off.)   For most roll-ups, amortization of intangibles is one of the largest expense items on the income statement. In 2010, EBIX amortized less than $3.8 million of intangibles, or only 2.8% of revenue. EBIX allocates a significant percentage of its acquisition price to goodwill and indefinite-lived intangibles, which are not amortized.  (Purchase price accounting treatments are fairly well established.  Acquirers do not have that much latitude in these calculations.  The difference between net assets and the purchase price is allocated to goodwill and intangibles.  Ebix is targeting companies that have few tangible assets.  There is little that Ebix can do to manipulate the total goodwill and intangible figures.)

About 90% of EBIX's goodwill and intangibles are classified as permanent. A shockingly low percentage is allocated to amortizable intangibles like customer relationships, developed technology, and trademarks. This is highly unusual for technology companies as advancements in technology make it nearly impossible to classify a contract, technology, trademark or customer relationship as indefinite (and able to contribute to cash flows into perpetuity), especially in highly competitive industries. This is highly suspicious and points again to a lack of oversight by the company's auditors with purchase price allocations and the desire to overstate earnings through lower amortization.

(The calculation of good will and non-amortizing intangibles as a portion of total intangibles as shown in Table 14 offered by the short-seller author is a meaningless measure.  One element is a diminishing category as a consequence of amortization and will by definition become a smaller portion of the total over time.  What is relevant is the amount of amortizing intangibles for each acquisition.

Intangible assets are defined as identifiable non-monetary assets that cannot be seen, touched or physically measured but identifiable as a separate asset. There are two forms of intangibles - legal intangibles [such as trade secrets like customer lists, copyrights, patents, and trademarks] and competitive intangibles [such market knowledge), collaboration activities, leverage activities, and structural activities].  To the extent that the purchase price can be attributed to this category, the excess of the purchase price over net assets will end up as an amortizing asset.

Ebix made a string of acquisitions in the last few years involving service providers and software developers, none of which had significant tangible assets.  Accordingly, a significant level of goodwill and intangibles have developed.  Approximately 14% and 21%, of the excess purchase price over tangible assets was allocated to amortizing intangible assets in the 2009 and 2010 acquistions, respectively.

The extent to which management has been able to influence these purchase price calculations to reduce the amortizing component is not clear.)  


Table 14 - Intangible Assets






12/31/09
3/31/10
6/30/10
9/30/10
12/31/10
Indefinite-lived intangibles
29,223
29,293
29,299
30,238
30,552
Goodwill
157,245
160,455
164,993
178,459
180,602
Goodwill and intangibles - not amortized
186,468
189,748
194,292
208,697
211,154
% of total
90.1%
90.2%
90.2%
89.9%
90.3%
Intangible, net (amortized)
20,505
20,641
21,019
23,402
22,574
Source: company filings







In 2010, EBIX benefited from a number of low quality and unsustainable earnings drivers that will make earnings comparisons difficult. For example, a change in fair value of a put option granted to the aforementioned E-Z Data acquisition benefited earnings by $0.15 ($6 million on the cash flow statement on 12/31/2010). This benefit was only prominently highlighted in the third quarter 2010.  Foreign exchange gains also added $1.9 million in 2010, or roughly $0.04 per share.  We have no doubt that EBIX will detail one-time expenses in the future as they become an earnings headwind.  (GAAP accounting requires both accounting treatments and disclosures. This is not a gimmick invented by Ebix.)

Please see Part III for additional research and our conclusion.

Disclosure: I am short EBIX.

Below is Part III of our EBIX report. Please see part one and two published earlier.

8) History of Auditor Turnover, Shockingly Low Audit Fees and Accounting Red Flags
Investors should view EBIX's stated financials with extreme skepticism given the myriad accounting and oversight issues. EBIX has had four different auditors over the past seven years. Two of the three auditors TERMINATED their relationship with EBIX per the company’s own filings. The only Big Four firm who audited the company was KPMG. According to the EBIX's filings, "KPMG LLP resigned as the independent registered public accounting firm of our Company" (our emphasis). Just prior to its resignation, KPMG found:

(1) delegation of authority and what KPMG considered to be inadequate reviews by a person other than the preparer of accounting information, (2) the lack of a formalized contract review process to ensure proper revenue recognition, (3) the lack of a complete understanding of the Company’s income tax positions and related accounts, (4) inadequate documentation for certain unusual transactions (including the basis for the Company’s accounting conclusions), and (5) internal control matters (documented and testable control environment) under the Sarbanes-Oxley Act.

(The paragraph above is not the language used by KPMG in the 2003 Ebix audit or in their response to Ebix 8K notice of the KPMG resignation and appointment of BDO.    The compete note on page 47 of the 2003 audit reads:

“In connection with the audit of the consolidated financial statements for the year ended December 31, 2003, KPMG LLP ("KPMG") advised our management and audit committee of reportable conditions with respect to our internal controls relating to, among other things, personnel and their roles and responsibilities. KPMG made certain recommendations to address these conditions and the Company is acting on those recommendations, including reorganizing the finance group and redistributing responsibilities and duties therein.”  The italics are ours to differentiate between the quotation and our commentary.)

To fully respond to the short-seller authors allegations it would be necessary to see the source for the quotation or paraphrase offered above.  The short-seller author offers a link to Ebix November 2005 proxy statement, which includes the same language as that found in KPMG’s response to the Ebix 8K notice of KMPG’s resignation.  The five items quoted by the short-seller author above are not found in that document.

Without the specific document where the short-seller found the list of five items we have to conclude the short-seller author is hoping no one will check on the voracity of their claims.)

Shortly after KPMG resigned, EBIX's new auditor, BPO Seidman, also "identified certain significant deficiencies relating to the Company’s internal control over financial reporting." (We were not able to find the filing from which this quotation was taken.)  In another peculiar move, "on December 12, 2008, Ebix, Inc. received notice from Habif, Arogeti & Wynne, LLP of its decision not to stand for re-appointment as Ebix’s independent registered public accountant."  (The full language of Ebix 8K filing is that the company had not yet decided to reappoint HA&W and that a selection process had already been started to find another auditor.  Furthermore, the same 8K filing includes a letter from HA&W stipulating that there was no disagreement between the Ebix and the firm and essentially stood by its audit of the year 2007.)

This is particularly shocking because Habif, Arogeti & Wynne is a small Georgia accounting firm. A public company like EBIX would be a prized client for a small firm like this. Additionally EBIX is in their backyard geographically. However, they decided to walk away. EBIX current auditor is the tiny firm Cherry, Bekaert & Holland. Despite the complexities of EBIX's financial shelters, EBIX only paid Cherry, Bekaert & Holland $343,250 and $262,500 for their 2009 and 2008 audits, respectively.

(Like Habif, Arogeti and Wynne, Cherry Bakaert & Holland is based on Georgia and is a member of Baker Tilly International.  However, to characterize CB&H as tiny is misleading.  CB&H is ranked among the top thirty CPA firms in the country with over 700 professionals and 99 partners.  This makes it larger than HA&W, which now has only 300 employees total and 48 partners.  HA&W is ranked among the top 100 firms in the U.S.  Thus in making the switch after one year to CB&H, Ebix made a significant step upward in the capacity of its auditor.  CB&H also completed the audit for the year 2010 although that is not included in Table 15 below.  That makes four auditors in eight years. 

BDO was late in completing its last audit of the year 2006, causing the company file past the deadline.  The reason cited by the company in its 10K-NT was the inability to complete accounting for a late 2006 acquisition. 

Management has suggested to analysts and investors that they changed auditors due to high fees and lack of presence in Atlanta. We find this explanation spurious at best. First, the company's own filings do not support that conclusion. Second, the history of audit fees at the company has been extraordinarily low (Table 15). And finally, each of these accounting firms has today, and always had, a major presence in the Atlanta market (including BDO).

Table 15 - EBIX Audit Fees








2003
2004
2005
2006
2007
2008
2009
Audit fees
290,000
325,927
270,000
532,000
322,600
262,500
343,250
Audit fees as a % revenue
2.0%
1.6%
1.1%
1.8%
0.8%
0.4%
0.4%
Auditor
KPMG
BDO
BDO
BDO
HA&W
CB&H
CB&H
Auditor II

KPMG





Source: company reports









We compared EBIX's audit fees to other public companies that analysts have used as comps for EBIX (we would disagree with some as explained below). EBIX pays audit fees that are a fraction of these companies.

(It would be suprising if Ebix paid as much as Salesforce.com, for example, for an annual audit.  In terms of revenue Salesforce.com is twelve times larger than Ebix.  NetSuite is a better comparison, but it to was still substantially larger than Ebix in 2008 and 2009.)
Table 16 - Audit Fees



2008
2009*
EBIX
262,500
343,250



salesforce.com (CRM)
4,122,950
4,227,563
NetSuite (N)
1,527,065
1,443,720
SuccessFactors (SFSF)
1,287,200
1,296,200
Solera (SLH)
3,553,000
3,768,000
ACI Worldwide (ACIW)
3,674,148
2,222,651
*2009 or latest fiscal year


Source: company filings




On conference calls, the CEO has stated that some of these former accounting firms have performed non-audit work as evidence that his company is not an accounting fraud. We would remind investors that Arthur Andersen was not put out of business because of their consulting work at Enron or E&Y was not charged with fraud at Lehman because of their tax work, it was because of the audit practices and procedures (the sacred cow of the Big Four business). We believe it is well known that accounting firms are much more judicious selecting audit clients, and much less so with non-assurance engagements.

Are four auditors in eight years a signal of problem accounting?  Ebix is a fast growing company with a need to keep costs low.  Furthermore, the changes in the accounting world since the Enron debacle in 2001 and the subsequent fallout in the audit industry in 2002 and 2003, led to a shuffling of accounts.  Firms such as KPMG seized the opportunity to migrate up the food chain to larger companies.  Ebix was not the only small fry that got left behind.  BDO went through significant changes and found itself overextended during the 2004 and 2005 time frame.  The Ebix audit was not the only audit BDO complete late in 2006.  

Frequent auditor changes are not the only questionable corporate governance issue at EBIX. In 2009, the board of director's approved one of the more unusual provisions that we have ever reviewed. EBIX's board "unanimously approved" a change in control provision. Under the provision, Robin Raina is guaranteed a cash payment of 20% of the difference between the transaction price and the valuation of the company at $7.95 per share in the event of a change in control.  (The Board did indeed approve this change in control bonus for Raina, citing protection against hostile take-over attempts, alignment with shareholder interests and retention as reasons for the potential bonus.)

While we highly doubt any buyer would pay anything near the current price for EBIX's hodge-podge of rolled up companies, the point is the Board is dominated by the CEO. Hypothetically, if EBIX could find a buyer, it would be Robin Raina who would get the massive payday, not shareholders.  (Shareholders would be paid whatever the offering price might be for each share.  Raina’s bonus would have to be paid from cash on the balance sheet.

The short-seller author misses the real risk in this discussion.  Is a large CEO bonus the only protection the board could find against hostile takeover?  Raina holds over a million options but few Ebix common shares.  What is the board’s policy vis-à-vis executive incentives?  Is sale of the company the only outcome the board wants to encourage?

The short-seller author neglects these questions perhaps because the answers are less cut and dried.  Insinuating Raina is a bad guy and greedy is more likey to motivate shareholders to dump shares.)

9) Controversial CEO Appears to Demonstrate a History of Misrepresentation

The CEO of EBIX, Robin Raina, dominates the organization. According to the latest proxy statement, Raina's compensation was 1,250% higher than any other employee at EBIX.  His cash compensation represented 12.3% and 15.9% of total general and administrative expenses in 2009 and 2008, respectively. To our knowledge, Raina does not allow analysts or investors access to other members of his management team. This alone is cause for concern about what Robin is hiding. The company's lack of bench strength will be on full display at their second ever analyst day on April 1st. This was apparent in the first investor day, held in December 2009.

The CEO has also sensationalized his history of charitable work. We highly admire charity work and believe people should be commended for it, especially those who conduct charitable work without the need for publicity or recognition. We do not believe Robin Raina and his "Robin Raina Foundation," fall into this category. The foundation's noble goal is to provide support for poor children in India. We commend the goal, but we question the execution. The foundation's website contains what appear to be outlandish statements, including:

He spends two continuous months every year working in the slums – meeting children, interacting with parents, helping build homes, playing cricket with blind kids etc. This is in addition to visiting India once every few months to do the same. On a typical day you could see him work 18 hours leading from the front.

Today, he his [sic] foundation has adopted in excess of 3500 children across the Indian sub continent in addition to presently carrying out the largest private charity initiative in the Indian sub-continent, in terms of building 6000 homes free of cost for the underprivileged.

FINAL SUMMARIZATION: When you consider his absolute excellence in the area of public service, it leaves you rather dazzled. When you consider that he does that while running one of the most successful companies on the NASDAQ with a shareholder return of 4,720% over the last 5 years, you marvel at his abilities to balance his zeal for charity with his work.

More troubling than the aggrandized claims is that they appear inconsistent with IRS filings. Given the claims, we assumed the foundation was a hundred million dollar organization. Information on the charity is available for 2004 through 2008. The charity is much smaller than The Raina Foundation suggests. Through 2007, the charity had less than $250,000 in assets. In 2008, assets grew with the addition of "equity securities," assumed to be EBIX stock.

Table 17 - Charity Assets





2004
2005
2006
2007
2008
Total Assets
$136,714
$232,292
$246,292
$246,794
$1,560,795
Source: IRS Form 990s






We found the 2007 IRS filing very peculiar. In 2007, the Robin Raina Foundation spent $143,933 (versus $246,794 of assets) on two fundraisers that "required a number of Bollywood singers performing for charity reasons" and "required the Indian musical legend Anup Jilota to sing his melodies to the crowd with his entire band in a live concert…at the Ashiana Restaurant." Also, in 2007 the foundation listed then EBIX CFO Richard Baum as the person responsible for the foundation's "books". In 2007 and 2008, EBIX donated $66,000 of shareholder money to the Robin Raina foundation.

In 2010, EBIX donated $39,000 to the foundation. Again, our aim in not attacking charitable work. What is apparent is that the charity seems to stroke Raina's ego by generating an enormous amount of press for the small organization and supported by the production of strange video tributes to Raina. It also appears that the enormous claims about the organization do not match the size and scope of its assets. By extension, it would seem that the charity has misrepresented its true character. We only highlight this because we see a similar misrepresentation with EBIX's businesses.

(We have little information at this time on Raina’s charitable work or the foundation named for him.  That Raina’s ego is stroked by his charitable work is hardly a matter relevant for the valuation of EBIX shares.  The only relevance it has in the Ebix discussion is whether the company may have inappropriately funneled monies to the foundation.)

10) SaaS Provider? We Think Not

EBIX has held itself out as a SaaS vendor - a business description that couldn't be further from the truth. In its press releases, EBIX describes its business with the statement: "through its various SaaS-based software platforms." Investors and analysts apparently have taken the bait. A recent initiation report by a firm called Craig Hallum described EBIX as "a provider of SaaS-based solutions for the insurance sector." A recent article on Seeking Alpha compared SaaS darling Salesforce.com (CRM) to EBIX. We find this comparison absurd.

SaaS business models are highly attractive for good reason. With a SaaS model, a company is able to collect subscription payments quarters or even years in advance, creating large deferred revenue. The SaaS provider has visibility into its earnings model as most of the revenue and earnings are pulled from the balance sheet. As a result, deferred revenue and bookings are the most important factor for SaaS stocks. In reviewing EBIX's results, the deferred revenue is virtually non-existent and has experienced negligible growth despite all of the acquisitions.

click to enlarge


This discrepancy is even more dramatic when you compare EBIX to "real" SaaS companies like Salesforce.com (CRM), Netsuite (N), SuccessFactors (SFSF), and Taleo (TLEO). As Table 19 illustrates, these companies typically have 1.5 to 4 quarters of deferred revenue on their balance sheet. In contrast, EBIX's deferred revenues can be measured in days and weeks due to its transactional nature. As a result, EBIX has minimal visibility relative to real SaaS providers.

Other parts of the income statements are also vastly different. The SaaS vendors listed below spend 40% - 50% of revenues on sales and marketing. EBIX spends 4.6% of revenues on sales and marketing, while R&D expense is roughly one-third compared to the other group.

(This line of reasoning is nonsense.  Software-as-a-Service or SaaS is a method of delivery for software applications.  It is possible to deliver software applications to users through a SaaS business model and do it well without creating lengthy streams of deferred revenue. 

Ebix 2010 10K provides a description of its revenue recognition policies.  The following is most pertinent:   “The Company begins to recognize revenue from license fees for its ASP products upon delivery and the customer’s acceptance of the software implementation and customizations if necessary and applicable. Transaction services fee revenue for this use of our exchanges or ASP platforms is recognized as the transactions occur and are generally billed in arrears. Service fees for hosting arrangements are recognized over the requisite service period.” The italics are ours to differentiate between the quotation from the 10K and our comments. 

The majority of Ebix revenue is generated by its ASP platforms (Application Service Provider), the way Ebix executes on its SaaS business model.  This revenue is recognized as transactions occur and the billing is sent.  Thus it does not lead to significant deferred revenue.  Service fees, which are recognized over a specified period are a small portion of the mix.

Table 19 is an apples and oranges comparison.


Table 19 - EBIX Vs. SaaS Models






EBIX
9/30/09
12/31/09
3/31/10
6/30/10
9/30/10
12/31/10
Deferred revenue
6,816
8,023
8,828
7,899
7,822
8,736
Def rev to current rev
0.3x
0.3x
0.3x
0.2x
0.2x
0.2x
Sales & Mkting as % rev
5.6%
4.8%
4.2%
5.4%
5.1%
4.6%
Product dev as % rev
12.9%
9.9%
10.6%
11.1%
9.9%
9.6%
CRM






Deferred revenue
545,435
704,348
664,529
683,019
694,557
934,941
Def rev to current rev
1.7x
2.0x
1.8x
1.7x
1.6x
2.0x
Sales & Mkting as % rev
46.0%
47.6%
46.7%
46.3%
46.7%
51.0%
Product dev as % rev
9.9%
10.3%
10.6%
10.9%
11.0%
12.6%
N






Deferred revenue
69,467
72,721
76,140
77,022
75,247
81,139
Def rev to current rev
1.7x
1.7x
1.7x
1.6x
1.5x
1.6x
Sales & Mkting as % rev
46.7%
45.7%
46.1%
46.5%
49.0%
50.3%
Product dev as % rev
17.7%
17.8%
18.2%
18.9%
19.1%
16.5%
SFSF






Deferred revenue
161,016
181,624
185,910
191,812
206,087
234,445
Def rev to current rev
4.2x
4.3x
4.2x
3.8x
4.0x
3.9x
Sales & Mkting as % rev
50.6%
50.5%
50.8%
44.0%
48.8%
49.0%
Product dev as % rev
16.4%
15.3%
17.6%
17.7%
21.4%
20.3%
TLEO






Deferred revenue
85,610
91,084
92,485
94,182
90,866
109,552
Def rev to current rev
1.7x
1.8x
1.7x
1.7x
1.5x
1.6x
Sales & Mkting as % rev
32.5%
32.1%
31.0%
32.2%
31.1%
36.1%
Product dev as % rev
17.1%
17.2%
18.3%
19.3%
17.4%
18.2%
Source: company filings








Another misrepresentation is EBIX's liberal use of the word "exchanges." According to EBIX, 70% of their revenues are derived from "exchanges." Listening to EBIX, an investor might expect them to operate a vibrant exchange where insurance policies trade back and forth in huge volumes as EBIX captures a piece of the spread. The same Craig Hallum initiation report on EBIX stated that "insurance exchanges are a greenfield opportunity with few comparables in other sectors."  (The use of the word “exchange” in the context of the insurance industry refers to an on-line marketplace where the insurance company that is Ebix customer is able to market their policies, sign up end-users and service claims.  Such exchanges in the insurance industry are a recent development that has come about as a part of the industry’s attempt to step forward into the 21st century and capitalize on efficiencies inherent in electronic commerce.  This is ludicrous commentary meant to inflame and not inform.)

In reality, these niche products are simply order entry systems and comparative raters, which have been around for decades and represent a highly competitive industry in insurance. EBIX states as much in the 10-k: "We operate in highly competitive markets. In particular, the online insurance distribution market, like the broader electronic commerce market, is rapidly evolving and highly competitive." EBIX's three most important products in their "exchange" segment are Winflex, LifeSpeed and Annuitynet. In its latest 10-k, the company describes each of these products as:
"Winflex is an exchange for pre-sale life insurance illustrations."
"LifeSpeed is an order entry platform."
"This exchange [Annuitynet] is an order entry platform for annuity transactions."

Simply put, Winflex is a comparative rater and LifeSpeed and AnnuityNet are order entry systems. This view is supported by EBIX's competition. In reviewing company literature for EBIX's private comps like Blue From and iPipeline, they describe their products as "order entry," "order management," and compliance programs. The word "exchange" is not used by EBIX's private competition. This is just another attempt by EBIX to manipulate investor perception.  (The short-seller author appears to make a strong case for the competitive strength of the Ebix offering over its competitors since the Ebix offering is more feature rich than the order entry products available from competitors.)

Conclusion

EBIX is a house of cards. EBIX currently trades at 20x 2010 EBITDA. EBIX trades at 16x 2011 EBITDA, or a 35% premium to the average multiple of high quality financial software providers that focus on banks, insurance, and other financials (SLH, SONE, ACIW, ONE, EPAY). EBIX investors face material downside and have significant exogenous risk from regulatory, tax, or oversight investigations. With a 5% organic growth rate, 28% operating margins (adjusted for the accounting irregularities and massive underinvestment in sales and R&D), and 35% tax rate, the company has less than $0.75 of earnings power currently.  

This margin would still represent one of the highest in the industry. At a very generous market multiple of 12x earnings (given minimal organic growth, a roll-up strategy, and issues presented above), we believe the stock is worth no more than $9.00 per share.

Disclosure: I am short EBIX. 

End of article published on Seeking Alpha by Copperfield Research.


(While there were important points made in the foregoing paragraphs, the sum total does not appear to support the characterization of Ebix as a “house of cards.”  The threat of regulatory, tax or oversight investigations is not supported.  Rather it portrays a company with an aggressive growth strategy and led by a dominant CEO. 

However, what is accomplished with some skill is a lengthy diatribe filled with lots of large numbers that appear to be out of normal and therefore fodder for concern.  It took two days to look up and verify or refute each of the claims made by this author yet the stock sold off by more than 20% within a couple of hours after the article appeared on-line.  Clearly, those who saw the article on the day it was published did not look past the inflammatory language.  This is a job well done by someone who sold the stock short before the article was published.



Neither the author of the Small Cap Strategist web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein. Crystal Equity Research has a Hold rating on EBIX.

4 comments:

Anonymous said...

Thank you for your great analysis. Copperfield Research is obviously attempting to manipulate the market.

Anonymous said...

One detail though: The CEO owns about 4 million shares, unlike what you wrote.

Salim Reza said...

I closed 16 short sales, in 2012 about 10, this year I'm not sure I will have any. ...
short sale

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