Thursday, December 29, 2011

Overstock.com Facing Dismal Fourth Quarter Numbers?

Yesterday, Overstock.com (NASDAQ:OSTK) disclosed that it was forced to pay off its existing obligations under a Master Lease Agreement with U.S. Bank to avoid an anticipated default under its covenants on December 31, 2011. So far, Overstock.com has lost $16 million in the first nine months of the year compared to only a $1.1 million loss during the previous year's nine month period. The termination of the Master Lease Agreement by Overstock.com to avoid a pending default appears to confirm that it will report dismal fourth quarter 2011 numbers.

According to the 8-K report filed with the Securities and Exchange Commission after the market closed on December 28, 2011:

On December 27, 2011 Overstock.com, Inc. (the “Company”) and U.S. Bancorp Equipment Finance, Inc. — Technology Finance Group (“Lessor”), agreed to terminate a Master Lease Agreement, dated September 17, 2010 (“Master Lease Agreement”) and all related schedules. The Company paid approximately $20.1 million to Lessor in connection with the amendment and agreement to terminate the Master Lease Agreement, including approximately $1.2 million in prepayment premiums. The aggregate amount the Company paid to amend the Master Lease Agreement and terminate the schedules associated with the Master Lease Agreement was less than the amount the Company would have been required to pay over the scheduled life of the Master Lease Agreement and all related schedules. By this transaction, the Master Lease Agreement was first amended to eliminate all financial covenants, effective immediately. Lessor also committed to convey to the Company all of the equipment and other assets covered by the Master Lease Agreement for no additional consideration.

The Company amended the Master Lease Agreement in order to eliminate the total fixed charge coverage ratio covenant under the Master Lease Agreement. As disclosed in the Company’s Form 10-Q for the quarter ended September 30, 2011, based on the Company’s results for the first three quarters of 2011, management considered it likely at that time that the Company would be out of compliance with the Master Lease Agreement’s total fixed charge coverage ratio covenant at December 31, 2011. In order to avoid a covenant violation, the Company amended the Master Lease Agreement to eliminate the financial covenants.
Lessor is an affiliate of U.S. Bank National Association (the “Bank”). The Company has a $20 million cash-secured credit facility with the Bank. The Bank or its affiliates have also provided other commercial services to the Company from time to time. [Emphasis added.]

Overstock.com tried to spin its termination of the Master Lease Agreement as positive news by claiming that the amount paid to US Bank was “was less than the amount the Company would have been required to pay over the scheduled life of the Master Lease Agreement and all related schedules." However, the company apparently agreed to pay the full obligation of $18.9 million that was due under the Master Lease Agreement as of December 31, 2011 plus applicable taxes and a stiff $1.2 million prepayment penalty. It was unable to restructure its Master Lease Agreement and obtain less stringent terms from U.S Bank.

As of September 30, 2011, OSTK owed US Bank $20.329 million under the Master Lease Agreement. $1.428 million of that amount was payable during the quarter ending December 31, 2011. (See Quarter Ended September 30, 2011 10-Q report page 17). Therefore, Overstock.com would have owed US Bank $18.901 million as of December 31, 2011 ($20.329 million less $1.428 million). The prepayment penalty amounts to approximately 6% of Overstock.com's obligation to U.S. Bank under the Master Lease Agreement as of December 31, 2011. That prepayment penalty will be reflected as charge to its otherwise expected dismal fourth quarter financial results. Furthermore, the company will have to take additional depreciation charges in future periods since it will take title to the equipment and other assets covered under the Master Lease Agreement.

Liquidity problems

As of September 30, 2011, Overstock.com reported that it had only $18.4 million in working capital. However, the company would have reported a mere $1.4 million of net working capital (current assets minus current liabilities) had it not played a shell game and window dressed its balance sheet during the third quarter.

On September 21, 2011, Overstock.com borrowed $17 million under a separate Financing Agreement (line of credit) with U.S. Bank and used $7.5 million of internal cash to redeem $24.5 million of convertible debt before its December 1, 2011 due date (10-Q report page 16 and 33). The convertible debt was classified on the company's balance sheet as a current liability. The $17 million that it borrowed under its Financing Agreement (line of credit) is a long term debt (noncurrent liability) because payment is due on December 31, 2012 (10-Q report page 42). Had Overstock.com not borrowed that $17 million from U.S. Bank to redeem its convertible debentures before the end of the third quarter (September 30, 2011), it would have ended the quarter with a mere $1.4 million in working capital (current assets less current liabilities). In any case, its balance sheet window dressing is temporary, since the $17 million it borrowed will become a current liability by the end of the first quarter of 2012 (March 31, 2012) which is traditionally a weak quarter for the company.

As of December 31, 2011, $12.959 million of Overstock.com's $18.901 million obligation under the Master Lease Agreement would have been classified as a long term liability. Since the company paid $20.1 million, including a $1.2 million prepayment penalty to terminate the Agreement, its working capital was apparently depleted by another $7.1 million ($20.1 million less $12.959 million).

In December 9, 2011, Overstock.com filed a shelf registration statement with the Securities and Exchange Commission that would allow it to sell up to $200 million of its debt securities, common stock, warrants and other securities. It appears likely that Overstock.com will need to do some sort of equity related offering in the first quarter of 2012 to stay afloat and avoid further liquidity problems. Such an offering will likely significantly dilute the value of existing common shares. (See Davian Letter "Overstock.com is Overstocked.")

On December 14, 2011, the company unloaded millions of dollars of excess inventory in a public auction and generated a mere $150,000 in cash, just pennies on the dollar.

Other issues

Patrick Byrne
Overstock.com also has to contend with an ongoing investigation by the Securities and Exchange Commission into securities law violations after this blog exposed it fabricating its earnings numbers. So far, every single financial report issued from its inception in 1999 to the third quarter of 2009 had to be restated up to three times due to violations of Generally Accepted Accounting Principles.

The company is being sued by District Attorneys from seven California District Attorneys who are alleging consumer fraud. They are seeking at least $15 million of restitution, fines, penalties, and cost reimbursements from the company for allegedly defrauding consumers. The Judge in that case had to compel an uncooperative Overstock.com to turn over information to the California District Attorneys.

Earlier in the year, Google penalized Overstock.com because it improperly gamed its search algorithm to boost its search rankings.

In October 2011, Overstock.com CEO Patrick Byrne, his hedge fund High Plains Investments LLC, Deep Capture LLC, and Mark Mitchell, a writer for Deep Capture, were sued in a Canadian court for defamation. Deep Capture LLC is an affiliate of Overstock.com and its website was used to promote Byrne's delusional conspiracy theories and libel company critics.

Latest deceptions

Back in January 2011, Overstock.com changed its name to O.co and directed its customers to use the O.co domain. As late as September 30, 2011, Patrick Byrne claimed in a press release that, "Our customers associate 'O' with Overstock.com, which made the transition to O.co seamless."

However, in the third quarter ended September 30, 2011, Overstock.com reported a $7.8 million loss compared to a $3.4 million loss in the previous year's quarter. Revenues during that quarter had declined by 2% to $239.7 million from $245.4 million dollars in the previous year. The company revealed that, "We also believe that our current efforts to rebrand ourselves from Overstock.com to O.co may have contributed to the decline in revenue." (See 10-Q page 33). Apparently, Overstock.com's transition to O.co was not as "seamless" as previously claimed by Byrne at the end of that same quarter. During a conference call with analysts, Patrick Byrne now admitted that customers found the transition was "confusing."

Jonathan Johnson
On November 14, 2011, Ad Age reported that the company's president, Jonathan Johnson also backpedaled on remarks made by Byrne at the end of its third quarter:

The online retailer's president, Jonathan Johnson, said it is stepping back from the O.co name "for now," though not abandoning it outright...."
Confused? So were customers. Mr. Johnson said customers responded well to the O.co advertising, but after watching the spots, "a good portion" of those who sought out the website went to O.com, instead of O.co. (O.com is one of the off-the-market single letter domain names still held by ICANN.)
"We were going too fast and people were confused, which told us we didn't do a good job," Mr. Johnson said.

Marketing Magazine put Overstock.com's rebranding efforts at the top of its list of 2011 marketing blunders.

Worst customer service in 2011

Just yesterday, the Huffington Post reported that, “The site with the dubious honor of proffering the worst customer service in 2011 was Overstock.com, those ubiquitous merchants of discounted furniture, clothes and home furnishing.”

Byrne sold shares before decline

Yesterday, Overstock.com common stock closed at $7.77 per share. Back on May 20 to May 24, 2010, Patrick Byrne's 100% controlled High Plains Investments LLC dumped 140,000 company shares at an average price of $22.11 per share and collected over $3 million in proceeds. Despite Byrne's optimistic forecasts, the company surprised investors and failed to meet analysts' consensus earnings expectations in the quarter ended June 30, 2010. Since the time Byrne has sold his stock, Overstock.com’s shares have dropped about 65% in market value and its market capitalization has dropped approximately $330 million.

Written by,

Sam E. Antar

Recommended Reading

Seeking Alpha: Green Mountain Coffee Roasters Surpasses Overstock.com As Worst Stock of 2011, By Gary Weiss

Davian Letter: Overstock.com continued....

Disclosure

I am a convicted felon and a former CPA. As the criminal CFO of Crazy Eddie, I helped my cousin Eddie Antar and other members of his family mastermind one of the largest securities frauds uncovered during the 1980's. I committed my crimes in cold-blood for fun and profit, and simply because I could.

If it weren't for the heroic efforts of the FBI, SEC, Postal Inspector's Office, US Attorney's Office, and class action plaintiff's lawyers who investigated, prosecuted, and sued me, I would still be the criminal CFO of Crazy Eddie today.

There is a saying, "It takes one to know one." Today, I work very closely with the FBI, IRS, SEC, Justice Department, and other federal and state law enforcement agencies in training them to identify and catch white-collar criminals. Often, I refer cases to them as an independent whistleblower. I teach white-collar crime classes for various government entities, professional organizations, businesses, and colleges and universities.

I do not seek or want forgiveness for my vicious crimes from my victims. I plan on frying in hell with other white-collar criminals for a very long time. My past sins are unforgivable.

I do not own any Overstock.com securities long or short.

Wednesday, December 14, 2011

Green Mountain Coffee Roasters: Where are the missing beans?

Just about every time I take a look at financial reports issued by Green Mountain Coffee Roasters (NASDAQ: GMCR), I found troubling discrepancies in its numbers. In the past, I’ve described how certain so-called restated numbers which purportedly corrected accounting errors in its Timothy’s subsidiary don’t appear to add up. Now, I’ve found even more puzzling numbers which raise more questions of whether its restatements of financial reports were actually correct.

On September 28, 2010, Green Mountain disclosed that the SEC started an informal inquiry into its revenue accounting practices and relationship with a certain fulfillment vendor eight days earlier. On that same day, the company coincidently reported that it discovered an accounting error involving its K-Cup margin percentages during the preparation of its financial report for the period ended September 25, 2010. On November 19, 2010, Green Mountain disclosed that it found four new accounting errors. On that date, the company said it would restate its financial reports issued from 2007 to the period ended June 26, 2010 to correct its errors and conceded that there were material weaknesses in internal controls.

On December 9, 2010, Green Mountain Coffee issued its 10-K report for the year ended September 25, 2010. That 10-K report included details of its restatements for various periods. For example, the company reported the following restated segment numbers for the quarter ended March 27, 2010 (See page F-64 and click on image to enlarge):




Future financial reports issued in the following fiscal year 2011 should reflect those same restated numbers. They don't. Furthermore, the revision of the restated numbers don’t seem to add up.

In the quarter ended March 26, 2011 10-Q report, showed the following restated segment numbers for the previous year’s thirteen week period ended March 27, 2010 (See page 14 and click on image to enlarge):


In the above 10-Q report, Green Mountain Coffee reduced the depreciation and amortization amount for the SCBU unit to $6.388 from the restated $8.062 million amount in the previous 10-K report. It increased the depreciation and amortization amount for the Corporate unit to $1.674 million from the restated $0 amount in the previous 10-K report. In other words, the company shifted $1.674 million of depreciation and amortization from its SCBU unit to its Corporate unit.

However, there were no changes income before taxes reported in any segment. Furthermore, there were no changes in any other income statement line items for its segments or in intercompany eliminations affecting those income statement line items. There were revisions in certain balance sheet line items. However, those balance sheet item revisions don’t explain why income before taxes were not changed in the SCBU unit or corporate unit. Therefore, if the company reduced depreciation and amortization expense in the SCBU segment and increased it in the corporate segment, its income before taxes should have increased in the SCBU segment and decreased in the corporate segment. I didn’t. The same issue continues to appear in subsequent 10-Q reports and even the annual audited 10-K report for fiscal year 2011.

Tracy Coenen, author of several forensic accounting books, once told me, "If a company cannot complete a simple task such as correctly adding or subtracting numbers, investors cannot trust anything in their financial reports." Historical numbers are supposed to be consistent from report to report, and the totals must be correct. At Green Mountain Coffee we continue to find the opposite - inconsistent historical numbers and numbers that don't add up.

Can anyone at Green Mountain Coffee explain the missing beans? Does the company add fudge to its coffee?

Written by,

Sam E. Antar

Recommended reading

Forbes: Some Advice for MF Global Employees - Start Cooperating With The Feds! by Walter Pavlo

Disclosure

I am a convicted felon and a former CPA. As the criminal CFO of Crazy Eddie, I helped my cousin Eddie Antar and other members of his family mastermind one of the largest securities frauds uncovered during the 1980's. I committed my crimes in cold-blood, for fun and profit, and simply because I could.

If it weren't for the heroic efforts of the FBI, SEC, Postal Inspector's Office, US Attorney's Office, and class action plaintiff's lawyers who investigated, prosecuted, and sued me, I would still be the criminal CFO of Crazy Eddie today.

There is a saying, "It takes one to know one." Today, I work very closely with the FBI, IRS, SEC, Justice Department, and other federal and state law enforcement agencies in training them to identify and catch white-collar criminals. Often, I refer cases to them as an independent whistleblower. Further, I teach white-collar crime classes for various government entities, professional organizations, businesses, and colleges and universities.

I do not own any Green Mountain Coffee Roasters securities long or short.

Monday, November 28, 2011

Did j2 Global Communications Fumble in Accounting?

Last week, I suggested that j2 Global Communications Inc. (NASDAQ:JCOM) could have misinterpreted certain accounting rules and that it should consider restating its financial reports issued in 2010. My analysis was based on a report issued by independent research firm Gradient Analytics and an examination of accounting rules and company disclosures. This blog post will examine how j2 Global has attempted to downplay certain problems in its financial reporting and provide even more compelling reasons for the company to consider restating its financial reports.

Background

Up to 2010, j2 Global apparently estimated the remaining life under its annual contracts with eFax customers to compute its deferred revenues, revenues, and earnings. In the first quarter 2011 10-Q report j2 Global disclosed that it upgraded its accounting systems and started using the actual useful life under its annual contracts with eFax customers to compute those numbers:

In the first quarter of 2011, the Company made a change in estimate regarding the remaining service obligations to its annual eFax subscribers. As a result of system upgrades, the Company is now basing the estimate on the actual remaining service obligations to these customers. As a result of this change, the Company recorded a one-time, non-cash increase to deferred revenue of $10.3 million with an equal offset to revenues. This change in estimate reduced net income by approximately $7.6 million, net of tax, and reduced basic and diluted earnings per share for the three months ended 03/31/11 by $0.17 and $0.16, respectively. [Bold/underline added for emphasis.]

The determination of the actual remaining life of an annual service contract involves a simple computation. For example, assume a company has a December 31 year-end. On November 1, a customer purchases an annual contract with an advance payment of $120. The company earns $10 per month under the annual contract ($120 divided by 12). At year-end, the company reports $20 of revenue to reflect income earned during November and December. In addition, it reports a deferred revenue liability of $100 to reflect the unearned income for the remaining 10 months under the contract. It’s not rocket science. Apparently, j2 Global’s accounting systems could not make such a computation, so the company estimated the number. It turns out that its estimates were significantly incorrect.

In the first quarter of 2011 j2 Global upgraded its accounting systems and was now able to calculate the actual remaining life under its annual service contracts with eFax customers. In that quarter, the company recorded a one-time cumulative adjustment to increase deferred revenues by $10.3 million, decrease in revenues by $10.3 million, and decrease net income by $7.6 million to accurately reflect its actual remaining service obligations under annual contracts with eFax customers.

Cumulative one-time adjustments in current periods relate to numbers reported in prior periods. Therefore, the company apparently understated its deferred revenue liability and overstated both revenue and net income reported in 2010 because it was unable to accurately measure the remaining life of annual service contracts with eFax customers. j2 Global claimed that those adjustments stemmed from a “change in estimate” under accounting rules. Therefore, it could use a one-time cumulative adjustment in the current quarter to correct unearned and earned income reported in previous periods.

Last week, independent research firm Gradient Analytics issued a report that questioned whether j2 Global appropriately treated those adjustments as a change in estimate. Based on its examination of the j2 Global’s financial disclosures, applicable accounting rules, and limited feedback from the company, Gradient reported that “…the description of the underlying circumstances sounds more like a correction of an error in prior-period financial results.” If those adjustments were considered an accounting error rather than a change in estimate, a restatement of j2 Global’s 2010 financial reports may be warranted if such errors are considered material under accounting rules.

Earlier company disclosures

For years, j2 Global warned investors about potential "failures or errors" in its billing systems. For example, in the 2010 10-K report issued just months before it made those one-time adjustments, the company disclosed:

We are in the process of upgrading our current billing systems to meet the needs of our growing subscriber base. Any failures or errors in our billing systems or procedures or resulting from any upgrades to our billing systems or procedures could impair our ability to properly bill our current customers or attract and service new customers, and thereby could materially and adversely affect our business and financial results. [Emphasis added.]

If there were no “failures or errors” in j2 Global’s billing systems, logically there would have been no one-time adjustments in the first quarter of 2011 to correct an understatement of deferred revenue liabilities and overstatement of revenues and net income reported in 2010. However, when the accounting adjustments came as warned, the company did not admit to any foul ups. In its first quarter 2011 10-Q report, it tried to put a good face on the issue. The company said it upgraded its systems and started using actual numbers for the remaining life of annual contracts to eFax customers. It's like an army general who doesn't want to admit retreat and brags about advancing to the rear.

SingerLewak LLP signed off on j2 Global's 2010 audit and internal controls on February 25, 2011, 56 days into the first quarter of 2011 (See 10-K report page 62). The close timing of the sign off by the auditors and the subsequent report of one-time adjustments raises concerns about the quality of their audit work and internal control environment at j2 Global.

Gradient raised similar concerns in its report:

Our research identified a number of troubling issues that point to a potentially weak audit-and-control environment. For example, the company’s disclosure of a $10.3 million one-time-target to revenue and offsetting increase in deferred revenue appears unusual in our view, and may be indicative of an error in in JCOM’s revenue reporting. In addition, we are concerned by management’s decision to omit disclosures relating to acquired revenues since 2010. We have further concern regarding PCAOB reports on the work of JCOM’s external auditor SingerLewak (hired in 2007) and a 2006-2007 internal investigation into incorrect stock-option-grant dates between 1999 and 2005.

A recent Public Company Accounting Oversight Board (PCAOB) inspection report issued on April 29, 2011, cited SingerLewak for various audit deficiencies, including "the failure to perform sufficient procedures related to the testing of revenue." The PCAOB report did not identify the company involved in that audit.

j2 Global attempts to play down significance of one-time adjustments

On May 5, 2011, CFO Kathy Griggs sought to downplay the significance of its one-time adjustments during the first quarter 2011 earnings call with investors and analysts:

The difference relates to a change in estimate implemented in Q1 2011 regarding our remaining service obligations to annual eFax subscribers. As a result of systems upgrades we are now basing the estimates on the actual remaining service obligations to these customers. As a result of this change we recorded a one-time noncash increase to our balance of deferred revenues of $10.3 million with an equal offset to revenues. This change is insignificant considering that our prior estimation techniques have been in place for over thirteen years, a period of which we reported over $1.6 billion in revenues cumulatively. [Emphasis added.]

The so-called first quarter 2011 “change in estimate” related to annual eFax subscribers. Logically, those one-time adjustments can only relate to revenues reported in 2010, not the entire thirteen year period. The adjustments increased deferred revenue liabilities by $10.3 million, decreased revenues by $10.3 million, and decreased net income by $7.6 million. Griggs used thirteen years of cumulative revenues amounting to $1.6 billion to make an inappropriate comparison to the $10.3 million revenue adjustment. She should have compared the $10.3 million revenue adjustment to $255.4 million of revenues reported in 2010.

Kathy Griggs tried to explain the significance of its one-time adjustments purely in terms as a percentage of cumulative revenues. That was wrong, too. Relatively insignificant misstatements in reporting revenues can have a significant effect on reported growth trends in revenues and earnings. Furthermore, relatively small revenue misstatements can hide a company’s failure to meet or beat analyst’s consensus earnings forecasts. Whether you call it a change in estimate or an accounting error, relatively small misstatements of revenues can have a significant impact on a company’s reported financial performance.

Was it a change in estimate or an accounting error?

Last week, Gradient Analytics examined j2 Global's first quarter 2011 10-Q report and questioned whether j2 Global had appropriately treated those adjustments as a change in estimate:

…the description of the underlying circumstances sounds more like a correction of an error in prior-period financial results. The distinction between a change in estimate and a correction of an error is important in that it may have implications for an evaluation of the effectiveness of internal controls.
Under U.S. GAAP, a change in accounting estimate occurs when new information or additional experience causes a company to change its estimate of an amount that is subject to uncertainty, such as future warranty obligations or the useful life of an asset. In contrast, errors result from mathematical mistakes in applying accounting principles or oversight, or misuse of facts that existed when preparing financial statements. In the case of JCOM, if the remaining service obligation for eFax customers can be determined with certainty, as is implied by the disclosure in the firm’s 10-Q it would appear to us to be a result of oversight of facts existing at the time of financial statement preparation. That is, the disclosure appears to indicate that the company’s internal control systems were not able to determine the remaining service obligation, despite the fact that the remaining service obligation was important both to revenue recognition and to customers who depend on accurate billing on their accounts and accurate tracking of remaining services they are owed. Furthermore, if the firm’s legacy system could not properly identify or track the underlying facts and figures required to properly value deferred revenue, as implied by the disclosure in the Q1 2011 10Q, it would appear to indicate a deficiency in internal control before Q1 2011.
In order to gain more clarity on this issue, we contacted the company on several occasions before publication. The first response we received was from investor relations (IR) representative Laura Hinson, who stated that the “systems upgrade permitted an accurate measurement of the remaining useful life of an annual customer and therefore permitted a more accurate measurement of the remaining useful life of an annual customer and therefore a more accurate picture of the amount of deferred revenue.” We followed up with a question asking why the company determined that the situation should be treated as a change in estimate, rather than the correction of an error. However, the company declined to answer our follow-up question. [Emphasis added.]

I'll try to explain the situation involving j2 Global's accounting issues in simple terms. A person could not count the fingers on his right hand without a calculator. He looked at his right hand and estimated that he had four fingers. After that person bought a calculator, he realized that there are actually five fingers on this right hand instead of four.

Is the one finger adjustment a change in estimate or an error under accounting rules? In such a case, the actual amount of fingers already existed, was not subject to uncertainty, and did not come about because of new information. Therefore, the adjustment should not be a change in estimate under accounting rules. The person made a mathematical error. The miscounting of fingers arose from an oversight or misuse of facts at the time they were counted. If he couldn't count his fingers, he should have used a calculator to count them. Therefore, the adjustment should be considered an accounting error. The same logic appears to apply to adjustments made by j2 Global to deferred revenues, revenues, and net income.

Gradient's concerns seem well-founded. If we are to accept j2 Global's rationale that its adjustments were a change in estimate, any public company that does not have adequate internal controls in place to report correct numbers can avoid reporting an accounting error when it turns out that previously reported numbers were incorrect.

j2 Global treated its adjustments of overstatements of deferred liabilities and understatement of revenue and earnings as a “change in estimate” under accounting rules. That allowed it to make a one-time cumulative adjustment in the current quarter to correct unearned and earned income reported in previous periods. If j2 Global had considered those adjustments as stemming from a material accounting error it would have been required to restate its previously affected financial reports rather than make a one-time adjustment.

Furthermore, it's troubling that j2 Global apparently stopped responding to Gradient as it made further inquiries about the change in estimate. Why clam up? The company did find time to comment about other aspects of Gradient's report to CNBC Senior Stock Commentator Herb Greenberg (Video link to "Herb Alert" on CNBC).

Materiality

If we assume that j2 Global’s adjustments to deferred revenue, revenue, and net income stemmed from an accounting error instead of a change in estimate, the next step is to determine if the misstatement was material in affected previous reporting reports. According to Securities and Exchange Commission Staff Accounting Bulletin No. 99 (SAB No. 99) some of the measures used to determine if accounting error is material are: “whether the misstatement masks a change in earnings or other trends” and “whether the misstatement hides a failure to meet analysts' consensus expectations for the enterprise.” If a misstatement causes a company to report an increase in revenues rather than properly report a decrease in revenues or if a misstatement hides a failure to match or beat analyst’s estimates, it is considered material and previously issued financial reports must be restated.

In the third quarter of 2010, j2 Global’s revenues increased by a mere $977,000 to $62.778 million compared to $61.801 million in the previous year’s third quarter. Its earnings per share matched the previous year’s comparable numbers – no growth. RTT News reported that j2 Global beat earnings beat analyst’s estimates by just $0.01 per share in both the third quarter and second quarter of 2010.

The understatement of deferred revenues and overstatement of revenues and earnings by j2 Global could have caused the company to report higher revenues and earnings per share in the third quarter of 2010 instead of lower revenues and earnings when compared to 2009's third quarter. In addition, they could have caused the company to beat analyst's estimates for third quarter and possibly the second quarter of 2010, too. Therefore, based on the size of the one-time adjustments it is possible there was a material misstatement of j2 Global’s financial performance in 2010.

Other items

In its recent 8-K report for the third quarter of 2011, j2 Global presented a full non-GAAP income statement and reconciled it side-by-side with its GAAP numbers. According to S.E.C. Regulation G Compliance and Disclosure Interpretations, the company cannot present a full non-GAAP income statement. See below:

Question 102.10
Question: Is it appropriate to present a full non-GAAP income statement for purposes of reconciling non-GAAP measures to the most directly comparable GAAP measures?
Answer: Generally, no. Presenting a full non-GAAP income statement may attach undue prominence to the non-GAAP information. [Jan. 11, 2010].

The company should change its future non-GAAP presentations to comply with S.E.C rules.

Closing comments

Whether or not there was a change in estimate or an accounting error, j2 Global needs to be more transparent with investors about its financial reporting issues. Mistakes happen. Best to be forthright about them early and move on, than to downplay them and create further investor uncertainty.

Written by,

Sam E. Antar

Update:

November 29, 2011: Fraud Files - j2 Global Communications Trying to Hide Accounting Errors by Tracy Coenen

March 8, 2012: Grumpy Old Accountants - JCOM: When Will The SEC Call and Error An Error by Ed Ketz and Anthony Catanach

Disclosure

I am a convicted felon and a former CPA. As the criminal CFO of Crazy Eddie, I helped my cousin Eddie Antar and other members of his family mastermind one of the largest securities frauds uncovered during the 1980's. I committed my crimes in cold-blood, for fun and profit, and simply because I could.

If it weren't for the heroic efforts of the FBI, SEC, Postal Inspector's Office, US Attorney's Office, and class action plaintiff's lawyers who investigated, prosecuted, and sued me, I would still be the criminal CFO of Crazy Eddie today.

There is a saying, "It takes one to know one." Today, I work very closely with the FBI, IRS, SEC, Justice Department, and other federal and state law enforcement agencies in training them to identify and catch white-collar criminals. Often, I refer cases to them as an independent whistleblower. Further, I teach white-collar crime classes for various government entities, professional organizations, businesses, and colleges and universities.

I do not seek or want forgiveness for my vicious crimes from my victims. I plan on frying in hell with other white-collar criminals for a very long time. My past sins are unforgivable.

I do not own any securities in j2 Global Communications, long or short. I am an eFax subscriber. In the past, I have permitted Sabrient Systems LLC, which owns Gradient Analytics, to republish certain of my blog posts as a professional courtesy. I have never received any compensation from either Sabrient or Gradient and have no financial relationship with either firm.

Tuesday, November 22, 2011

Should j2 Global Communications Restate its 2010 Financial Reports?

j2 Global Communications Inc. (NASDAQ:JCOM) may have misinterpreted certain accounting rules and needs to consider restating its financial reports issued in 2010 based on certain new information it obtained from a “systems upgrade” in early 2011 that “permitted an accurate measurement of the remaining useful life” in its annual contacts with eFax customers.

Background

If a customer pays an annual fee in advance, a company reports a deferred revenue liability (unearned fees) because the fee is not yet earned. As time progresses on the annual contract, the company reduces its deferred revenue liability and increases its revenues as those fees are earned. Up to 2010, j2 Global apparently estimated the actual remaining life under those contracts to compute its deferred revenues, revenues, and earnings.

In the first quarter of 2011, j2 Global upgraded its accounting systems and started using the actual useful life under its annual contracts with eFax customers to compute deferred revenues, revenues, and net income. In that quarter, the company recorded a one-time cumulative adjustment to increase deferred revenues by $10.3 million, decrease in revenues by $10.3 million, and a decrease in net income of $7.6 million to accurately reflect its actual remaining service obligations under annual contracts with eFax customers. Cumulative one-time adjustments in current periods relate to numbers reported in prior periods. Therefore, the company apparently understated its deferred revenue liability and overstated both revenue and net income reported in 2010 because it was unable to accurately measure the remaining life of annual service contracts with eFax customers.

j2 Global claimed that those adjustments stemmed from a “change in estimate” under accounting rules. Therefore, it could use a one-time cumulative adjustment in the current quarter to change unearned and earned income reported in previous periods.

Gradient Analytics questions accounting treatment

Yesterday, independent research firm Gradient Analytics issued a report that questioned whether j2 Global appropriately treated those adjustments as a change in estimate. Based on its examination of the j2 Global’s financial disclosures, applicable accounting rules, and limited feedback from the company, Gradient reported that “…the description of the underlying circumstances sounds more like a correction of an error in prior-period financial results.” If those adjustments are appropriately considered an accounting error rather than a change in estimate, a restatement of j2 Global’s 2010 financial reports may be warranted if such errors are considered material under accounting rules.

Was there a change in estimate or an accounting error?

Gradient Analytics suggests that j2 Global should have considered adjustments affecting deferred revenues, revenues, and net income as stemming from an accounting error, rather than a change of estimate:

One of the most significant quality-of-earnings-specific concerns noted during our analysis of JCOM was the unusual nature of the $10.3 million one-time charge to revenue and offsetting increase in deferred revenue (previously discussed). The disclosure in question is copied below in its entirety (Q1 2011 10Q):
"In the first quarter of 2011, the Company made a change in estimate regarding the remaining service obligations to its annual eFax subscribers. As a result of system upgrades, the Company is now basing the estimate on the actual remaining service obligations to these customers. As a result of this change, the Company recorded a one-time, non-cash increase to deferred revenue of $10.3 million with an equal offset to revenues. This change in estimate reduced net income by approximately $7.6 million, net of tax, and reduced basic and diluted earnings per share for the three months ended 03/31/11 by $0.17 and $0.16, respectively. [bold/underline added for emphasis]"
Based on this disclosure, it appears that JCOM is asserting that it was unable to determine the actual remaining service obligation to its customers before Q1 2011. However, because of an upgrade to its internal accounting systems, the company is now able to determine the actual amount of remaining customer obligations. Furthermore, the above disclosure implies that deferred revenue was previously understated by approximately $10.3 million. It follows that recognized revenue was overstated by the same amount over some number of periods before Q1 2011.
While there is little question that prior-period revenues were overstated by approximately $10.3 million, it is not entirely clear why this occurred. That is, while management has elected to treat this new information as a change in accounting estimate, the description of the underlying circumstances sounds more like a correction of an error in prior-period financial results. The distinction between a change in estimate and a correction of an error is important in that it may have implications for an evaluation of the effectiveness of internal controls.
Under U.S. GAAP, a change in accounting estimate occurs when new information or additional experience causes a company to change its estimate of an amount that is subject to uncertainty, such as future warranty obligations or the useful life of an asset. In contrast, errors result from mathematical mistakes in applying accounting principles or oversight, or misuse of facts that existed when preparing financial statements. In the case of JCOM, if the remaining service obligation for eFax customers can be determined with certainty, as is implied by the disclosure in the firm’s 10-Q it would appear to us to be a result of oversight of facts existing at the time of financial statement preparation. That is, the disclosure appears to indicate that the company’s internal control systems were not able to determine the remaining service obligation, despite the fact that the remaining service obligation was important both to revenue recognition and to customers who depend on accurate billing on their accounts and accurate tracking of remaining services they are owed. Furthermore, if the firm’s legacy system could not properly identify or track the underlying facts and figures required to properly value deferred revenue, as implied by the disclosure in the Q1 2011 10Q, it would appear to indicate a deficiency in internal control before Q1 2011.
In order to gain more clarity on this issue, we contacted the company on several occasions before publication. The first response we received was from investor relations (IR) representative Laura Hinson, who stated that the “systems upgrade permitted an accurate measurement of the remaining useful life of an annual customer and therefore permitted a more accurate measurement of the remaining useful life of an annual customer and therefore a more accurate picture of the amount of deferred revenue.” We followed up with a question asking why the company determined that the situation should be treated as a change in estimate, rather than the correction of an error. However, the company declined to answer our follow-up question.

If we assume that j2 Global’s adjustments to deferred revenue, revenue, and net income stemmed from an accounting error instead of a change in estimate, the next step is to determine if the misstatement was material in affected previous reporting reports. Further analysis is provided below.

Materiality

If an accounting error is material, a company is required to restate its financial reports to correct the error. According to Securities and Exchange Commission Staff Accounting Bulletin No. 99 (SAB No. 99) one of the measures used to determine if accounting error is material is “whether the misstatement masks a change in earnings or other trends.” For example, if a misstatement causes a company to report an increase in revenues rather than properly report a decrease in revenues, it’s considered material. Another measure used to determine materiality under SAB No. 99 is “whether the misstatement hides a failure to meet analysts' consensus expectations for the enterprise.” In other words, if a misstatement causes a company to match or beat analyst’s estimates, it is considered material.

As I detailed above, j2 Global first quarter 2011 adjustments reduced revenues by $10.3 million and reduced basic and diluted earnings per by $0.17 and $0.16, respectively. Those adjustments appear to affect 2010’s reported numbers.

In the third quarter of 2010, j2 Global’s revenues increased by a mere $977,000 to $62.778 million compared to $61.801 million in the previous year’s third quarter. In addition, its third quarter 2010 earnings per share matched the previous year's comparable numbers. RTT News reported that j2 Global beat earnings beat analyst’s estimates by just $0.01 per share in the third quarter of 2010 :

Excluding share-based compensation expense, non-GAAP earnings was $21.75 million or $0.47 per share compared to $21.36 million or $0.47 per share last year. On average, nine analysts polled by Thomson Reuters expected the company to earn $0.46 per share in the quarter. Analysts' estimates typically excludes special items. [Emphasis added.]

Therefore, if j2 Global's adjustments to revenue and net income are considered accounting errors, they could have caused the company to report higher revenues and earnings per share in the third quarter of 2010 compared to the previous year's third quarter. In addition, they could have caused the company to beat analyst's estimates for third  quarter and possibly the second quarter, too.

RTT News reported that j2 Global’s second quarter 2010 earnings beat analyst’s estimates by just $0.01 per share:

Net earnings per diluted share on a Non-GAAP basis, which excludes share-based compensation and related payroll taxes and certain acquisition costs, was $0.46….
On average, 9 analysts polled by Thomson Reuters expected the company to report profit of $0.45 per share for the quarter. Analysts' estimates typically exclude special items. [Emphasis added.]

Assuming that j2 Global’s adjustments to revenues and net income are considered accounting errors, the relative size of those adjustments compared to the company’s second and third quarter financial results suggest that such misstatements could be material and a restatement of financial reports is warranted.

Written by,

Sam E. Antar

Update

March 8, 2012: Grumpy Old Accountants - JCOM: When Will The SEC Call and Error An Error by Ed Ketz and Anthony Catanach

Disclosure

I am a convicted felon and a former CPA. As the criminal CFO of Crazy Eddie, I helped my cousin Eddie Antar and other members of his family mastermind one of the largest securities frauds uncovered during the 1980's. I committed my crimes in cold-blood for fun and profit, and simply because I could.

If it weren't for the heroic efforts of the FBI, SEC, Postal Inspector's Office, US Attorney's Office, and class action plaintiff's lawyers who investigated, prosecuted, and sued me, I would still be the criminal CFO of Crazy Eddie today.

There is a saying, "It takes one to know one." Today, I work very closely with the FBI, IRS, SEC, Justice Department, and other federal and state law enforcement agencies in training them to identify and catch white-collar criminals. Often, I refer cases to them as an independent whistleblower. Further, I teach white-collar crime classes for various government entities, professional organizations, businesses, and colleges and universities.

I do not seek or want forgiveness for my vicious crimes from my victims. I plan on frying in hell with other white-collar criminals for a very long time. My past sins are unforgivable.

I do not own any securities in j2 Global Communications, long or short. I am an eFax subscriber. In the past, I have permitted Sabrient Systems LLC, which owns Gradient Analytics, to republish certain of my blog posts as a professional courtesy. I have never received any compensation from either Sabrient or Gradient and have no financial relationship with either firm.

Tuesday, November 15, 2011

Nature's Sunshine Products, Willbros Group, Cal Dive International, and BSQUARE Violate S.E.C. Rules on Calculating EBITDA

Nature’s Sunshine Products (NASDAQ: NATR), Willbros Group (NYSE: WG), Cal Dive International (NYSE: DVR), and BSQUARE (NASDAQ: BSQR) have recently issued earnings reports which include a calculation of EBITDA (earnings before interest, taxes, depreciation, and amortization) that apparently does not comply with Securities and Exchange Commission interpretations for Regulation G governing such non-GAAP financial measures. In each case, their erroneous EBITDA calculations have enabled them to significantly distort their financial performance by erroneously reporting a positive EBITDA, when they should have reported a negative EBITDA in the latest quarter.

How EBITDA is supposed to be calculated under Regulation G

According to the S.E.C. Compliance & Disclosure Interpretations, EBITDA is defined under Regulation G as net income (not operating income) before net interest, taxes, depreciation, and amortization. See below:

Question 103.01
Question: Exchange Act Release No. 47226 describes EBIT as "earnings before interest and taxes" and EBITDA as "earnings before interest, taxes, depreciation and amortization." What GAAP measure is intended by the term "earnings"? May measures other than those described in the release be characterized as "EBIT" or "EBITDA"? Does the exception for EBIT and EBITDA from the prohibition in Item 10(e)(1)(ii)(A) of Regulation S-K apply to these other measures?
Answer: "Earnings" means net income as presented in the statement of operations under GAAP. Measures that are calculated differently than those described as EBIT and EBITDA in Exchange Act Release No. 47226 should not be characterized as "EBIT" or "EBITDA" and their titles should be distinguished from "EBIT" or "EBITDA," such as "Adjusted EBITDA." These measures are not exempt from the prohibition in Item 10(e)(1)(ii)(A) of Regulation S-K, with the exception of measures addressed in Question 102.09. [Jan. 11, 2010]
Question 103.02
Question: If EBIT or EBITDA is presented as a performance measure, to which GAAP financial measure should it be reconciled?
Answer: If a company presents EBIT or EBITDA as a performance measure, such measures should be reconciled to net income as presented in the statement of operations under GAAP. Operating income would not be considered the most directly comparable GAAP financial measure because EBIT and EBITDA make adjustments for items that are not included in operating income. [Jan. 11, 2010]

The proper way for a public company to compute EBITDA under Regulation G is by starting the calculation with net income (not operating income) and only adding back net interest, taxes, depreciation and amortization. A public company cannot add back other items such as stock-based compensation costs, impairments of fixed assets, or anything else to compute EBITDA. Such errors can materially overstate EBITDA and lead to potential regulatory sanctions. Any different calculation cannot be called EBITDA, but it can be called "Adjusted EBITDA" or some other appropriate name.

Examples of erroneous EBITDA calculations uncovered by the Securities and Exchange Commission

Reviews of public company financial reports by the S.E.C Division of Corporation Finance highlight how EBITDA is required to be computed under Regulation G.

In September 2007, the Division of Corporation Finance told CGG Veritas that its EBITDA calculation erroneously included an adjustment for stock-based compensation:

The acronym EBITDA refers specifically to earnings before interest, tax, depreciation and amortization. However, your measure also adjusts earnings for stock option expense. We will not object to your using such a measure as a liquidity measure but request that you rename it to avoid investor confusion.

In March 2010, the Division of Corporation Finance told Crown Crafts that its EBITDA calculation erroneously included an adjustment for asset impairment charges:

We note that your calculation of EBITDA in the press release furnished as an exhibit includes an adjustment for goodwill impairment charges. As such, the non-GAAP measure should not be characterized as EBITDA. When you include an adjustment that is not included in the definition of EBITDA as set forth in Item 10(e) of Regulation S-K, please revise the title of the non-GAAP measure to clearly identify the earnings measure being used and all adjustments. Refer to question 103.01 of the Division’s Compliance & Disclosure Interpretations on the use of non-GAAP measures available on our website http://sec.gov/divisions/corpfin/guidance/nongaapinterp.htm.

In March 2010, the SEC Division of Corporation Finance told General Finance Corporation that its EBITDA calculation improperly included an adjustment for foreign currency gains and losses:

We note that the measure you call EBITDA does not appear consistent with the definition of EBITDA since it excludes foreign currency exchange (gain) loss and other. Please revise the title of this non-GAAP measure in future filings to accurately reflect the items being excluded. For further guidance see Question 103.01 of our Compliance and Disclosure Interpretation on Non-GAAP Financial Measures, available on our website at www.sec.gov/divisions/corpfin/guidance/nongaapinterp.htm.

Below, I will detail how Nature's Sunshine, Willbros Group, Cal Div, and BSQUARE all used improper adjustments to EBITDA which enabled them to report a positive EBITDA instead of a properly calculated negative EBITDA.

Nature’s Sunshine

In the quarter ended September 30, 2011, Nature’s Sunshine erroneously included share-based compensation expense, contract termination costs, and foreign exchange gains or losses in its EBITDA calculation. In the quarter ended September 30, 2010, it erroneously included loss from discontinued operations, share-based compensation expense, and foreign exchange gains or losses in its EBITDA calculation. See the yellow highlighted items below from its 8-K filing. (Click on image to enlarge):




Note: According to the company's 8-K report, “Other income (expense), net is primarily comprised of foreign exchange gains (losses), interest income, and interest expense.” As I detailed above, foreign currency gains or losses cannot be properly included in an EBITDA calculation.

Nation’s Sunshine should have reported a negative EBITDA in both the three months ended September 30, 2011 and 2010, rather than a positive EBITDA in each period. It erroneously claimed that its EBITDA had doubled to positive $11.505 million in its latest quarter compared to a positive $5.074 in the prior year’s comparable quarter.

Based on my calculations, it should have reported a negative EBITDA of $2.887 million in the quarter ended September 30, 2011 compared to a negative EBITDA of $2.5 million in the previous year's comparable quarter. In other words, its financial performance, as measured by EBITDA, seems like it got worse in 2011 compared to 2010, not better. See my calculations below. (Click on image to enlarge):




Note: The company did not specify the amount of foreign exchange gains or losses for the respective three month periods ended September 30, 2011 and 2010. I was able to calculate that amount by subtracting the totals for the respective six month periods ended June 30, 2011 and 2010 from the totals for the respective nine month periods ended September 30, 2011 and 2010. (See the Statement of Cash Flows in the June 30, 2011 10-Q and September 30, 2011 10-Q reports).

Willbros Group, Inc.

In both the quarters ended September 30, 2011 and 2010, Willbros erroneously started its EBITDA calculation with net income (loss) from continuing operations, rather than net income (loss). In addition, the company erroneously included goodwill impairment costs in its EBITDA calculation. See yellow highlighted items below from 8-K filing. (Click on image to enlarge):



Willbros should have reported a negative EBITDA of $113.640 million instead of a positive EBITDA of $32.186 million for the quarter ended September 30, 2011. In addition, it should have reported a positive EBITDA of $64.035 million instead of a positive EBITDA of $78.745 million for the quarter ended September 30, 2010. Its financial performance, as measured by a correct EBITDA calculation, got worse in latest quarter compared to the previous year. See my calculations below. (Click on image to enlarge):




Cal Drive International

In the quarter ended September 30, 2011, Cal Dive erroneously included non-cash stock compensation expense and non-cash fixed assets impairment charges in its EBITDA calculation. In the quarter ended September 30, 2010, Cal Dive erroneously included non-cash stock compensation expense, non-cash goodwill impairment charge, and non-cash fixed assets impairment charges in its EBITDA calculation. See the yellow highlighted items below from its 8-K filing. (Click on image to enlarge):




Cal Div should have reported a negative EBITDA of $20.839 million instead of a positive EBITDA of $18.363 million for the quarter ended September 30, 2011. In addition, it should have reported a negative EBITDA of $267.078 million instead of a positive EBITDA of $50.330 million for the quarter ended September 30, 2010. See my calculations below. (Click on image to enlarge):





BSQUARE Corp

In the quarters ended September 30, 2011 and 2010, BSQUARE erroneously included stock-based compensation expense in its EBITDA calculation. See the yellow highlighted items below from its 8-K filing. (Click on image to enlarge):




In addition, BSQUARE disclosed that "Other income or expense consists of interest income on our cash, cash equivalents and investments, gains and/or losses recognized on our investments, as well as gains or losses on foreign exchange transactions." Investment gains or losses and foreign exchange gains or losses cannot be included in an EBITDA calculation. However, the company did not specify such amounts in its recent S.E.C. filings, though they seem to be minimal given the total amounts reported for other income (expense) in each quarter, detailed above.

If we assume no other erroneous items were used in its EBITDA calculation, the company should have reported a negative EBITDA of $0.281 million instead of a positive EBITDA of $0.297 million for the quarter ended September 30, 2011. Further, it should have reported a positive EBITDA of $1.210 million instead of a positive EBITDA $1.486 million in the previous year's comparable quarter.

Other companies identified by this blog using erroneous EBITDA calculations

In the past, this blog has identified eight other companies who used improper EBITDA calculations. Seven of them promptly corrected their EBITDA calculations after this blog reported them. The other company, Overstock.com, now known as O.co, led by Patrick Byrne defiantly refused to correct its improper EBITDA calculations for almost two years. Finally, under pressure, it complied with Regulation G. After this blog uncovered violations of Generally Accepted Accounting Principles (GAAP) which helped Overstock.com fabricate profits, the S.E.C. Enforcement Division opened an investigation of the company for violations of various securities laws. That investigation is ongoing.

Closing comment

The management and audit committees of Nature's Sunshine, Willbros Group, Cal Dive International, and BSQUARE need to study SEC rules governing the calculation of non-GAAP measures such as EBITDA and follow them in future filings. I will continue tracking future financial reports to see if they miscalculate EBITDA and violate Regulation G again.

Written by,

Sam E. Antar

Disclosure

I am a convicted felon and a former CPA. As the criminal CFO of Crazy Eddie, I helped my cousin Eddie Antar and other members of his family mastermind one of the largest securities frauds uncovered during the 1980's. I committed my crimes in cold-blood for fun and profit, and simply because I could.

If it weren't for the heroic efforts of the FBI, SEC, Postal Inspector's Office, US Attorney's Office, and class action plaintiff's lawyers who investigated, prosecuted, and sued me, I would still be the criminal CFO of Crazy Eddie today.

There is a saying, "It takes one to know one." Today, I work very closely with the FBI, IRS, SEC, Justice Department, and other federal and state law enforcement agencies in training them to identify and catch white-collar criminals. Often, I refer cases to them as an independent whistleblower. Further, I teach white-collar crime classes for various government entities, professional organizations, businesses, and colleges and universities.

I do not seek or want forgiveness for my vicious crimes from my victims. I plan on frying in hell with other white-collar criminals for a very long time. My past sins are unforgivable.

I do not own any securities of any of the public companies referred to in this blog post, long or short.

Monday, October 31, 2011

Overstock.com (O.co): Insolvency Looming?

Updated at bottom of blog post to include analyst downgrade

Overstock.com (NASDAQ:OSTK), also known as O.co, faces possible insolvency if current earnings trends continue and it cannot restructure two loans with U.S. Bank, its biggest creditor by March 31, 2012 at the latest. In an apparent effort to mask its weakening net working capital position, it played a shell game to window dress its balance sheet at the end of the third quarter (September 30, 2011). Overstock.com owed U.S. Bank $20.329 million under the “Master Lease Agreement” (sale-leaseback) and another $17 million under a “Financing Agreement” (line of credit). Therefore, the company owes U.S. Bank $37.329 million under two loan agreements.

Last week Overstock.com surprised investors by reporting a third quarter $7.8 million net loss (diluted earnings per share of negative $0.33) compared to a net loss of $3.4 million (diluted earnings per share of negative $0.15) in the previous year’s third quarter. Its net loss was $0.10 per share higher than was projected by Wall Street analysts. So far, Overstock.com has lost $16 million in the first nine months of the year compared to only a $1.1 million dollar loss during the previous year's nine month period.

"Likely" breach of debt covenant buried in footnotes

As I described in my last blog post, the company buried news of an impending default in its Master Lease Agreement (sale leaseback) with U.S. Bank on page 43 of its footnotes in its third quarter 10-Q report. The Master Lease Agreement with U.S. Bank requires Overstock.com "…to maintain a minimum Total Fixed Charge Coverage annualized ratio of at least 1.20:1.00, based on operating results, measured at the end of each fiscal quarter." The company revealed that, "… based on the results for the first three quarters of 2011, it is likely that we will be out of compliance with the Total Fixed Charge Coverage ratio at December 31, 2011 unless current trends improve substantially. We have held initial and collegial discussions with U.S. Bank regarding this potential non-compliance."

The 10-Q report gives a peek into Overstock.com’s "current trends" and since it was filed 27 days into the 92 day fourth quarter. According to the company’s own analysis, the projected fourth quarter numbers don’t look good “unless current trends improve substantially” in the next few weeks.

Window dressing its balance sheet

At the end of its third quarter, the Overstock.com had $18.4 million of net working capital (current assets minus current liabilities). However, the company would have reported a mere $1.4 million of net working capital had it not played a shell game and window dressed its balance sheet during the third quarter. Apparently, the company wanted to avoid reporting dangerously low net working capital going into the fourth quarter, while at the same time it is trying to renegotiate terms of its Master Lease Agreement (sale leaseback) with U.S. Bank.

On September 21, 2011, Overstock.com borrowed $17 million under its Financing Agreement (line of credit) with U.S. Bank and used $7.5 million of internal cash to redeem $24.5 million of convertible debt before its December 1, 2011 due date (10-Q report page 16 and 33). It could have waited until the fourth quarter to redeem its convertible debt when it was due. Further, the convertible debt was unsecured debt, while the amount it borrowed from U.S. Bank is secured debt.

The convertible debt was classified on the company's balance sheet as a current liability at the end of its second quarter. The $17 million that it borrowed under its Financing Agreement (line of credit) is a long term debt (noncurrent liability) because payment is due on December 31, 2012 (10-Q report page 42). The company used secured long term debt (noncurrent liability) to replace an unsecured current liability in the quarter before its payment was due.

Had Overstock.com not borrowed that $17 million from U.S. Bank to redeem its convertible debentures before the end of the third quarter (September 30, 2011), it would have ended the quarter with a mere $1.4 million in working capital (current assets less current liabilities). In any case, its balance sheet window dressing is temporary, since the $17 million it borrowed will become a current liability by the end of the first quarter of 2012 (March 31, 2012) which is traditionally a weak quarter for the company.

Liquidity issues

CEO Patrick Byrne
At the end of the third quarter (September 30, 2011), Overstock.com owed U.S. Bank $20.329 million under its Master Lease Agreement (sale leaseback). As I detailed above, the company revealed that if current trends don’t "substantially improve" it "likely" won't be in compliance with certain minimum financial benchmarks required under the agreement. According to the Master Lease Agreement, an "Event of Default" includes the "...failure of Lessee to perform any term, covenant or condition of the Lease...." In such a case, if the company cannot restructure its Master Lease Agreement with U.S. Bank, the lender can require the company to immediately pay "…the entire amount of rent and other sums…."

$14.485 million of the $20.329 million Overstock.com owed U.S. Bank under its Master Lease Agreement (sale leaseback) was classified as long term debt (noncurrent liability) as of the end of the third quarter (September 30, 2011). As I detailed above, Overstock.com had only $18.4 million of net working capital at the end of the third quarter. By window dressing its balance sheet, the company made it appear that it had adequate net working capital to pay all amounts due under that agreement in the event of a potential default. Even if we set aside the window dressing issue, the company barely had enough net working capital to pay all amounts due under the Master Lease Agreement in the event of a potential default.

The company is required to have $30 million in compensating balances deposited at U.S. Bank against its Master Lease Agreement (sale leaseback) and Financing Agreement (line of credit). Excluding those $30 million compensating cash balances, the company had only $95.8 million of current assets available to cover $101.6 million of current liabilities as of the end of its third quarter. (Note: The $101.6 million current liabilities amount excludes $5.8 million of current liabilities under the Master Lease Agreement).

In other words, Overstock.com could have a difficult time paying debts as they come due if continues to maintain $30 million in compensating cash balances at U.S. Bank. Further, the $17 million it borrowed under the Financing Agreement becomes classified at a current liability in the first quarter of 2012 which will reduce net working capital by the same amount.

Overstock.com may have to reduce its $30 million of compensating balances on deposit with U.S. Bank. However, if the company does not maintain its compensating balances with U.S. Bank it would default on both loan agreements totaling $37.3 million. Therefore, Overstock.com also may have to renegotiate its Financing Agreement (line of credit) with U.S. Bank.

Other issues

Overstock.com also has to contend with an ongoing investigation by the Securities and Exchange Commission into securities law violations after this blog exposed it fabricating its earnings. So far, every single financial report issued from its inception to Q3 2009 had to be restated up to three times due to violations of Generally Accepted Accounting Principles.

The company is being sued by District Attorneys from seven California District Attorneys who are alleging consumer fraud. They are seeking at least $15 million of restitution, fines, penalties, and cost reimbursements from the company for allegedly defrauding consumers. The Judge in that case had to compel an uncooperative Overstock.com to turn over information to the California District Attorneys.

Earlier in the year, Google penalized Overstock.com for improperly gaming its search algorithm to boost its search rankings.

Two weeks ago, Overstock.com CEO Patrick Byrne, Deep Capture LLC, and Mark Mitchell, a writer for Deep Capture, were sued in a Canadian court for defamation. Deep Capture LLC is an affiliate of Overstock.com and its website was used to promote Byrne's delusional conspiracy theories and libel company critics. The judge ordered the Deep Capture website shut down.

Written by,

Sam E. Antar

Update

Two days after the above post post was published, TheStreet Wire "downgraded" Overstock.com "from hold to sell" based on the following issues:
The company, on the basis of change in net income from the same quarter one year ago, has significantly underperformed when compared to that of the S&P 500 and the Internet & Catalog Retail industry. The net income has significantly decreased by 131.9% when compared to the same quarter one year ago, falling from -$3.36 million to -$7.79 million.
The debt-to-equity ratio is very high at 2.34 and currently higher than the industry average, implying that there is very poor management of debt levels within the company. Along with the unfavorable debt-to-equity ratio, OSTK maintains a poor quick ratio of 0.84, which illustrates the inability to avoid short-term cash problems.
Return on equity has greatly decreased when compared to its ROE from the same quarter one year prior. This is a signal of major weakness within the corporation. Compared to other companies in the Internet & Catalog Retail industry and the overall market, OVERSTOCK.COM INC's return on equity significantly trails that of both the industry average and the S&P 500.
The gross profit margin for OVERSTOCK.COM INC is rather low; currently it is at 16.10%. It has decreased from the same quarter the previous year. Along with this, the net profit margin of -3.20% trails that of the industry average.
Net operating cash flow has decreased to $7.24 million or 11.92% when compared to the same quarter last year. Despite a decrease in cash flow of 11.92%, OVERSTOCK.COM INC is in line with the industry average cash flow growth rate of -15.64%.
Recommended Reading

Overstock.com Nears Default While Utah Media Sleeps, by Gary Weiss

Green Mountain Coffee: Accounting Irregularities and Other Concerns, by Tracy Coenen

How to Commit Short Sale Fraud ...And Get Away With It, by Monique Byrher

Advance Praise for Ayn Rand Nation, by Gary Weiss

Disclosure

I am a convicted felon and a former CPA. As the criminal CFO of Crazy Eddie, I helped my cousin Eddie Antar and other members of his family mastermind one of the largest securities frauds uncovered during the 1980's. I committed my crimes in cold-blood for fun and profit, and simply because I could.

If it weren't for the heroic efforts of the FBI, SEC, Postal Inspector's Office, US Attorney's Office, and class action plaintiff's lawyers who investigated, prosecuted, and sued me, I would still be the criminal CFO of Crazy Eddie today.

There is a saying, "It takes one to know one." Today, I work very closely with the FBI, IRS, SEC, Justice Department, and other federal and state law enforcement agencies in training them to identify and catch white-collar criminals. Often, I refer cases to them as an independent whistleblower. I teach white-collar crime classes for various government entities, professional organizations, businesses, and colleges and universities.

I do not seek or want forgiveness for my vicious crimes from my victims. I plan on frying in hell with other white-collar criminals for a very long time. My past sins are unforgivable.

I do not own any Overstock.com securities long or short.