Is Model N A Transparency Violation?

As many of you might suspect, this grumpy old accountant is not a big fan of last year’s JOBS Act.  As so eloquently communicated by Andrew Ross Sorkin in “JOBS Act Jeopardizes Safety Net for Investors,” my primary concern is the decreased amount of time that investors now have to analyze critical corporate information.  Three weeks is simply not enough to evaluate the financial viability of a company before it goes public.  As Mr. Sorkin suggests, the Act:

“dismantles some of the most basic protections for the most susceptible investors apt to be drawn into get-rich-quick scams and too-good-to-be-true investment ‘opportunities’.”

So, when Model N founder and CEO Zack Rinat told Maxwell Murphy at the CFO Journal recently that the Company believes in “complete transparency,” and won’t use the JOBS Act to hide material information from investors, I just had to take a look.  Now I can’t promise the Company that it would have avoided my scrutiny had it gone through the normal IPO filing process, but it sure would have gotten some good comments that would truly have helped the CEO honor his transparency pledge to investors.  My review of Model N’s Amendment  No. 4 to Form S-1 Registration Statement filed on March 15, 2013 (S-1), did not disappoint.

Two things immediately tipped me off that this was going to be an interesting read.  First, there was the unlabeled circular graphic presumably depicting the life cycle of revenue management using the Company’s solutions that preceded the table of contents.  Not until page 86 of the S-1 does the Company actually attempt to explain this illustration.  Then, there was the Company’s motto, “More Revenue, Made Simple.”  I found this marketing hype particularly annoying since it challenges the intelligence of experienced business professionals who recognize there is nothing easy about creating customer value.  So, right out of the gate we have transparency issues.

Next, there is the issue of what the Company actually does.  The reader must wade through page after page of MBA speak (85 pages in fact) to learn what the Company’s strategy and business model is.  Why mystify us with such terms as “revenue management solutions, strategic end-to-end process, application suites, and domain expertise” when the Company is nothing more than another software provider attempting to remedy the age old problems of transaction processing, reporting, and system integration.  Why all the marketing spin, legalese, and accounting verbosity?  All of this detracts from transparency. 

Then, there are the numerous questions raised by the Company’ s historical operations.  We learn early on that an investment in Model N is quite risky (S-1, page 4).  Recent operating losses, dependence on a few key customers (75 percent of revenues come from 15 customers), reliance on a single product, and a single industry focus all make this grumpy old accountant wonder what makes this Company “worthy” of an IPO.  

And then you have the declining margin issue masked in the Summary Consolidated Financial Data (S-1, page 8).  Margins on license and implementation products have decreased from almost 62 percent in 2010 to 54.81 percent at the end of the most recent fiscal year end. Why is this? Wouldn’t it be more transparent to explicitly report this very troubling trend in the introductory summary table?  

Instead, we don’t even see these negative margin trends until page 59 of the S-1.  Sure, Model N provides exhaustive detail of revenue and cost of goods sold changes, but it does so without answering the million dollar question: why the margin erosion?  Excuse me, but this is a pretty significant transparency deficiency.

And of course, as with so many IPO’s today, the Company feels compelled to spin its losses into profits via non-GAAP performance metrics (i.e., adjusted EBITDA).  When we get to the EBITDA reconciliation (S-1, page 10), we learn that the biggest reconciling item is for something called “LeapFrogRx compensation charges,” but the LeapFrogRx transaction has not been detailed up to this point in the S-1.  Again, is this what transparency is all about? And this is significant.  If not for the LeapFrogRx compensation charges and stock-based compensation, there would have been no need for “adjusted EBITDA” at all!  By the way, the LeapFrogRx transaction is not even mentioned until page 49 of the S-1, and we don’t get any of the specifics until much later in the actual financial statements (S-1, F-21 and F-22).  

As an aside, I particularly got a kick out of the Company’s justification for paying an excess purchase premium for LeapFrogRx: synergies in skill-sets, operations, customer base and organizational cultures.  Goodwill impairment can’t be far behind, can it?  And, oh by the way, why is stock-based compensation going up as the Company begins to lose money (S-1, page 9)?  Another transparency issue?

As I navigated the Company’s risk factor section (S-1, page 15), I was stunned to see accounting policies listed as a risk factor!  Essentially, Model N is “warning” potential investors that its reported revenues may be lower than they “really” are because of accounting.  Specifically: 

“Our revenue recognition model for our cloud-based solutions and maintenance and support agreements also makes it difficult for us to rapidly increase our revenues through additional sales in any period, as a significant amount of our revenues are recognized over the applicable agreement term.”

Does the Company require a specific type of accounting to report profitability? Unbelievable! Such disclosure does little to enhance transparency.

And the Company continues to imply that accounting will somehow “hurt” the business (S-1, page 31) in the following risk disclosures:

“Our financial results may be adversely affected by changes in accounting principles generally accepted in the United States...If our estimates or judgments relating to our critical accounting policies are based on assumptions that change or prove to be incorrect, our operating results could fall below expectations of securities analysts and investors, resulting in a decline in our stock price.”

Why is the Company warning us so much about the accounting?  Is there a problem?  Should we even be relying on the S-1?  Again, transparency sure seems to be an issue.

And if Model N is so transparent, why did it take advantage of certain exemptions from reporting requirements that public companies make, including not complying with auditor attestation requirements of Section 404 of Sarbanes-Oxley, reduced disclosure of executive compensation, etc. (S-1, page 32).  And then there is the issue of how Model N management intends to use the funds received in the IPO.  Surely, a Company wouldn’t do an IPO if it didn’t have some idea of how the proceeds would be used.  Yet, once again, Model N fails the transparency test by not telling us its plans for the monies raised (S-1, pages 36 and 41).

And then there are the bookkeeping errors (S-1, page F-18).  Is it really transparent to label accounting mistakes as “out-of-period adjustments?”  You make the call.

Finally, it is noteworthy that Model N reported income tax expense in 2012 even though it reported a pre-tax loss for the period.  The reason: a significant increase in its valuation allowance for deferred tax assets suggesting poor future operating performance prospects even with an IPO (S-1, F-32).  Then there is the issue of whether the IPO will trigger Section 382 limitations on the Company’s net operating loss carryovers.  While the Company does identify this as a risk (S-1, page 34), it seems to suggest that this “might” occur when in reality the likelihood is significantly greater than might.  This disclosure clearly plays down the loss of this asset, and again causes one to question the Company’s transparency.

Sujan Jain, Model N’s CFO, in the aforementioned CFO Journal indicated that filing offering plans confidentially with the SEC allowed the Company to avoid distractions of early IPO publicity.  You tell me…are the issues I raised “distractions?”  I think not…and to take a page from the beloved radio announcer Paul Harvey, “and now you know the rest of the story.”
But there’s more.  Earlier this week, Model N issued a press release to report its second quarter fiscal year 2013 results.  And once again, the Company disappointed us with its lack of transparency by introducing new non-GAAP metrics: non-GAAP gross profit, non-GAAP research and development expenses, non-GAAP sales and marketing expenses, and non-GAAP general and administrative expenses. Clearly, Model N is learning the new IPO game. But is this accounting-conflicted, non-GAAP focused, JOBS Act loving Company transparent?

This essay reflects the opinion of the author and not necessarily that of The American College, or Villanova University.

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AuthorAnthony Catanach
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Groupon Revisited: New Mission, New Reporting Issues

It’s been over six months since the Grumpies’ last Groupon commentary.  Remember the financial restatements, revenue corrections , SEC criticism of the Company’s non-GAAP performance metrics, the internal control weaknesses over financial reporting, and public critiques of reported operating cash flows? Well, quite honestly, many of us had just tired of the Company’s story, until recently that is.  But two events during the past month, Andrew Mason’s “resignation” and the Company’s 2012 10-K securities filing, made it impossible for me to remain silent any longer.  As the marketing slogan suggests, Groupon is simply “the gift that keeps on giving.”

First, there’s Mr. Mason’s so-called “resignation” letter.  Let’s be clear here…according to Groupon’s Form 8-K filed on February 28th, “Andrew D. Mason was terminated as Chief Executive Officer.”  Unbelievable are those that actually praised Mr. Mason’s letter.  But what really troubles me is that at least one person found his memo to employees “geeky, hilarious, and touching,” and another titled it a “charming goodbye letter.” I think more appropriate descriptors might be immature and irresponsible.  Why am I being so grumpy about this?  Let’s not forget that the Company incurred a $9 billion loss in value (a decline from a $12.7 billion IPO valuation to an estimated $3 billion value on February 28th) during his tenure as CEO.  Phrases like “ I’m OK with having failed at this part of the journey,” or “maybe I’ll figure out how to channel this experience into something productive” are simply not acceptable. And for those that applaud his wisdom about having the “courage to start with the customer,” what about the investors?  How could Mr. Mason have forgotten about them in his letter? Those who invested $9 billion in his business education should be outraged!  His company’s loss in market capitalization makes today’s college tuition look amazingly affordable, if not downright cheap.  Okay, enough of Mr. Mason…let’s turn to Groupon’s most recently filed 10-K.

The first thing the 10-K does is confirm what Matthew Lynley reported in “Groupon Is No Longer a Daily Deals Business.”  It appears that the Company has a new mission.  According to last year’s 10-K:

“Groupon is a local commerce marketplace that connects merchants to consumers by offering goods and services at a discount…By bringing the brick and mortar world of local commerce onto the Internet, Groupon is creating a new way for local merchant partners to attract customers and sell goods and services.”
— 2011 10-K, page 3

But the recently filed 2012 10-K reveals a major change that has profound implications for Groupon’s business model and processes:

“Our mission is to become the operating system for local commerce. Groupon seeks to reinvent the traditional small business world by providing merchants with a suite of products and services, including customizable deal campaigns, credit card payments processing capabilities and point-of-sale solutions to help them attract more customers and run their operations more effectively.”
— 2012 10-K, page 3

Apparently, management finally realized that its original “daily deals” strategy just wasn’t creating much value or delivering on the differentiation dimension. So, now Groupon has decided to pursue a more Amazon-like approach.  While a dubious strategic shift, it does makes sense given Jason Child’s (Chief Financial Officer) tenure with Amazon from 1999 to 2010 (2012 10-K, page 11).  Also, don’t forget that Jeffrey Holden, Sr. Vice President of Product Management, also spent time at Amazon between 1997 and 2006 (2012 10-K, page 11).  When a plan is not working, it is not uncommon for some managers to fall back on what they know best.

But before we get to the financials, let’s reflect on what the Company’s redirection means for performance measurement (i.e., the numbers).  A new strategy means new processes, which in turn affect metrics and reported results. This means that traditional financial statement analysis (FSA) cannot be relied upon to provide its usual meaningful results.  FSA’s ratio and trend analyses are founded on the assumption of stable relationships, so when a company is transforming itself, the usefulness of these tools is somewhat limited.  Further complicating FSA is the Company’s decision to reclassify financial statement items from prior years (2012 10-K, page 69).  Does Groupon bother to tell us where the changes are?  Of course not.  Nevertheless, here are a few grumpy observations.

My biggest concern is the Company’s continuing struggle with estimates (and judgment).  Remember how the grumpies complained last August about Groupon’s “unusual” gain on an e-commerce transaction that created second quarter profitability (see Groupon: Still Accounting Challenged)?  This was a gain driven solely by the Company’s own estimates of fair value, the reasonableness of which we questioned at the time.  Well, guess what?  We were right again!  In the fourth quarter (literally at the eleventh hour), the Company revised its value estimate of its F-tuan investment downward by almost 40 percent resulting in a write-down of $50.6 million (2012 10-K, page 84). This turnabout almost completely reverses the pre-tax $56 million gain that Groupon reported in the second quarter of 2012. 

And while I’m on the topic of estimates and valuation, let’s not forget intangibles. Goodwill just keeps on growing from 9.4 percent of assets in 2011 to 10.17 percent in 2012.  With the Company’s new mission and related business models, one can’t help but wonder what the implications are for previously recorded goodwill, particularly since the Company couldn’t get F-tuan’s number right.  And a change in strategic direction clearly must impact intangibles.  In fact, cracks are beginning to appear in the goodwill numbers.  International segment revenue actually declined 15.9 percent in the final quarter of 2012 (2012 10-K, page 38) raising questions about reported international goodwill amounts.  More troubling is that liabilities exceed assets for the EMEA and LATAM reporting units, and that Groupon actually looked at possible impairment for these units this year (2012 10-K, page 53).  Ultimately, the Company decided that no write-down was necessary, but you have been warned again.  In fact, I suspect this year’s 10-K language may be signaling an impairment charge in the very near future.

And then there is the Company’s deferred tax asset (DTA) intangible.  As you may recall, the Grumpies first sounded the alarm on this intangible almost one year ago exactly in “Groupon’s First 10-K: Looking Under the Hood.” Well, guess what?  The Company is still reporting a loss because it FINALLY recorded an allowance for the DTAs which it likely will never (ever) be able to use.  It’s the increase in the DTA allowance (and several other tax factors) that drove the Groupon’s effective tax rate to an astronomical 153.7 percent in 2012 (see 2012 10-K, pages 46, 54, 104, and 114).  This is what we warned you would happen in our previous blog postings, and it has come to pass.  This is just more evidence of the Company’s struggle to make reliable estimates.  If I were the regulators, I would consider the Company’s F-tuan write-down, it’s delay in reserving for its DTAs, and its forthcoming goodwill impairment as evidence of a potential material weakness in controls over financial reporting as it relates to fair value estimation.  Heads up SEC…you too E&Y!

No review of Groupon would be complete without a discussion of non-GAAP performance metrics, and the Company does not disappoint us again.  Yes, Groupon still relies on non-GAAP metrics (2012 10-K, page 47), but there are changes. The Company has shed its infamous CSOI metric in favor of “operating income (loss) excluding stock-based compensation and acquisition-related expense (benefit), net.”  What would the acronym for this mouthful be?  OIESBCAEN?  I think I liked CSOI better…nevertheless, it’s still a curious metric that inflates operating performance.  And there’s more…last year, the gross billings metric was considered by the Company to be an “operating metric” (2011 10-K, page 41), while now it is reported as a financial metric (2012 10-K, page 31).  

What’s the big deal?  Gross billings is a total sales number that does not deduct the merchant’s share of transaction revenue.  Thus, gross billings is not a valid financial performance indicator…for goodness sakes, it doesn’t even appear in the financial statements. Moreover, to report gross billings as a financial performance metric actually decreases financial reporting transparency!  Why?  Well, Groupon reports growth rates in gross billings of 35 percent and 434.7 percent for 2012 and 2011, respectively (2012 10-K, page 35).  Yet gross profit (a “real” financial indicator) decreased from 83.9 percent in 2011 to 69.2 percent in 2012 (2012 10-K, page 41).  Now, you tell me…which sounds better, huge growth rates in gross billings or declines in gross profit?

While I’m on the topic of performance, despite the declines in gross profit percentage, income from operations has turned positive for the first time primarily due to reduced marketing expenses. The dramatic reversals in marketing and selling, general, and administrative (SG&A) expenses may reflect the Company’s changing business model, but given Groupon’s past reporting issues, one wonders if some of this expense volatility is due to the aforementioned decision to reclassify financial statement items.  Just a thought. And did you notice that the percentage of stock based compensation as a percent of operating expenses is increasing (2012 10-K, page 35)?  Why are managers continuing to reward themselves so highly despite continued losses, diminishing growth, and stock price declines?

Could there possibly be anything else you ask?  Well yes, there are a couple of lesser financial reporting issues that continue to irritate this grumpy old accountant.  Operating cash flows (OCF) have declined in 2012 despite accounts receivable liquidations, and the decrease is largely due to diminishing contributions of merchant payable flows to reported OCF.  We warned you about this in “Groupon’s First 10-K: Looking Under the Hood.”  

And why isn’t inventory reported separately as a current asset on the balance sheet?  Given the Company’s new retail strategy, the $40 million inventory amount reported in the notes (2012 10-K, page 89), and the existence of separate accounting policy note (2012 10-K, page 70), inventory has earned its own line item disclosure on the face of the balance sheet.

Then there is the Company’s segment disclosure. Groupon acknowledges having four reporting units: North America, Europe, Middle East and Africa (EMEA), Asia Pacific (APAC), and Latin America (LATAM) (2012 10-K, page 70). Yet, the Company only discloses two business segments, North America and International.  Oh, Groupon is probably GAAP compliant here basing their reporting on the size of the individual reporting units.  But why can’t the Company just report all four units, and why the need to deduct certain expenses in calculating segment operating income (see note (2) in 2012 10-K on page 106)?  Is this the 2012 version of last year’s CSOI?

So, where does all of this leave us? 

  • The Company is operating without a permanent CEO. 
  • The Company has abandoned its old mission in favor of a new one.
  • The Company is transitioning to an untested business model which raises serious balance sheet valuation questions, particularly given management’s recent estimation difficulties.
  • The Company continues to struggle with providing consistent and reliable financial reports, its efforts now further complicated by its current state of flux.
You tell me.  At my advancing age, I just can’t take any more April Fool’s Day surprises!

This essay reflects the opinion of the author and not necessarily that of The American College, or Villanova University.

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AuthorAnthony Catanach
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Chimera: So Many Questions, Too Few Answers

The last I heard, the purpose of financial reporting was to provide information that investors, creditors, and others can use to make decisions.  Well, when a publicly traded company fails to file its required financial statements, and market regulators let it get away with it, that’s a real problem.  How are investors and creditors supposed to evaluate their investments?  And that’s the $3 billion question being asked of Chimera (CIM) by Aaron Elstein in “A mythical name and profits, too?”

Here is a company that has neither filed a quarterly report since November 18, 2011 (for the quarter ended September 30, 2011), nor an annual report since February 28, 2011 (for the year ended December 31, 2010).  Yet, securities regulators permit Chimera to operate, and allow its stock to be listed and traded.  John Maxwell at the Motley Fool has described this situation as “inexcusable,” and that’s an understatement, for all the questions this situation raises.

Okay, why no financial statements? According to its Form 8-K filing with the Securities and Exchange Commission (SEC) on March 1, 2012, the Company needed additional time to “review the application of GAAP guidance to certain of its non-Agency assets.”  But then the story gets interesting when Chimera “fires” Deloitte as its auditor on March 11, 2012, replacing them with Ernst & Young.  What’s particularly curious is that the Company kept Deloitte to audit its 2011 10-K which has yet to filed. Then, in an August 1, 2012 Form 8-K filing, we learned of Chimera’s erroneous accounting for its non-agency residential mortgage-backed securities portfolio.  Basically, the Company accounted for this portfolio as if it were high credit quality, rather than reflecting its actual poor quality, necessitating a correction to reduce net income by almost $700 million during the affected reporting period (fiscal years ended 2008 through 2010).  And just recently, on March 1, 2013, Chimera notified the SEC in a Form NT 10-K filing that its annual financial statements for the fiscal year ended December 31, 2012 are not yet ready either.  However, there is a bit of good news…according to the filing, Chimera has finally completed its review of the accounting policies for its non-agency residential mortgage-backed securities portfolio, and that its 2011 annual report is forthcoming.  Better late than never, right?  Well, that’s just the first of my many questions.

Let’s start with the accounting error, or as today’s politically correct accountants call it, the restatement.  Given all of the expertise that Deloitte’s New York office presumably gained accounting for, auditing, and valuing financial instruments during the financial crisis of 2007 and 2008, it is unbelievable that it didn’t discover the “erroneous” accounting earlier.  My review of Chimera’s 2010 10-K uncovered plenty of clues that the Company’s non-agency residential mortgage-backed securities (RMBS) portfolio was “poor quality.”  Here are just a few:

  • Page F-14 reveals that non-agency RMBS with an estimated fair value of $2.5 billion had over $412 million in unrealized losses.  That’s unrealized losses of over 14 percent of their cost.
  • Page F-15 reports that 48.1 percent of all RMBS’s are rated below B or are not rated at all.
  • Page F-17 indicates that non-agency RMBS are collateralized by Alt-A mortgages of subprime fame, 56.1 percent of which were originated during the 2007 pre-bust mortgage boom, and 57.8 percent financed properties in the overheated California market.
So you tell me…does that sound like a high quality mortgage securities portfolio?  How could such an “error” have occurred?  Surely it wasn’t due to accounting ineptitude, after all, according to Aaron Elstein, Chimera's CEO received $35 million in compensation in 2011. That kind of money should buy some expertise, right?  And according to the Company’s proxy statement (Schedule 14A) Deloitte received a whopping $827,625 in audit and audit related fees for 2010 for its work on what should be a fairly straight-forward engagement.  The balance sheet is nothing more than securities funded by repurchase agreements and collateralized debt.  How could Deloitte not see the accounting problem for three years?  
Given the magnitude of this accounting “bust,” it’s pretty clear that Chimera’s internal controls over financial reporting don’t work, and Deloitte will no doubt confirm that in the near future (and after the fact).  However, given that the Company has only been operating since November 21, 2007, I would have thought that Deloitte would have carefully scrutinized accounting policies and procedures for this young entity, particularly with such rapid growth in the high risk RMBS portfolios.  Chimera’s total assets increased over 400 percent between fiscal year ends 2007 and 2010 (2010 10-K, 50).  And again, this is Deloitte New York…a Big Four firm center stage on Wall Street.  Is it any wonder they were fired?
But that raises yet another question?  You can’t fault Chimera for canning Deloitte, but why rely on the firm that couldn’t find the accounting problem to “fix” it? That’s right…E&Y doesn’t take over as auditor until the 2012 fiscal year engagement.  It just gets “curiouser and curiouser!”  Oh, you might argue that the Company will save money by having Deloitte clean up its (Chimera’s) mess, but let’s be realistic…E&Y is going to bill Chimera heavily anyway when it takes over given the material weaknesses, accounting errors, risky investments, and valuation issues.  E&Y is going to re-audit a lot of what Deloitte does anyway, so why not just have E&Y audit the delinquent years and restatements?
And then there’s the delay in fixing the accounting.  With all of Deloitte New York’s 2007 financial crisis expertise, as well as the Company’s own management experience, why is it taking so long to fix the books and issue an audit report?  Could the tardiness be signaling something else?  Is the situation worse than represented?  Are the books and records in shambles?  Or is it the RMBS portfolios that are causing the problems…after all these are Alt-A loans?  And then there’s always the possibility of an auditor-client conflict despite what is documented in the auditor termination letters.  It would not be surprising if the two parties disagreed over the magnitude of the RMBS valuation adjustments.  Or has the audit been completed, and Deloitte is “sitting” on the report at the client’s request for some reason?  See what kinds of questions surface when a company is not transparent?
And if you think these concerns are too farfetched, what about the creditors?  According to Chimera’s 2010 10-K (F-22 and F-23), the Company’s RMBS portfolios were funded significantly by short-term repurchase agreements (repos) and securitized debt.  How are these creditors functioning without some type of valuation information?  Normally, short-term repo borrowings are re-priced and renewed based on underlying collateral values.  Since the Company has not been forced into bankruptcy by these lenders, it seems reasonable to assume that these creditors have renewed Chimera’s short-term borrowings.  But what collateral valuation data did these creditors use to make their refinancing decisions?  Did they receive some “private” RMBS information that was not made available to investors and regulators?  If so, that might suggest that the delays in correcting the accounting error and issuing financial statements may be unjustified, right?  

And then there are the regulators…why do they “rubber stamp” extension request after extension request by the Company?  According to Chimera’s February 14, 2013 Form 8-K, the New York Stock Exchange has given the Company one final extension until March 15th to file its 2011 10-K.  So some very stale data may be forthcoming shortly.  But can’t the NYSE see the potential problems associated with the issues raised above?  And given the tardiness of the 2011 10-K, why is the NYSE cutting Chimera so much slack with the delinquent 2012 10-K?

See what chaos a lack of transparency in financial reporting can create?  Chimera is definitely living up to its name when it comes to its financial reports…for the past months, the Company’s reports have been nothing more than a “fanciful mental illusion” that create so many questions, and provide too few answers.  In a post 2007 financial crisis environment, one would not have expected that such a situation would be tolerated.

This essay reflects the opinion of the author and not necessarily that of The American College, or Villanova University.

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AuthorAnthony Catanach
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