Naveen Reddy, Director of Ratings
On Thursday, Ebix’s shares declined by almost 27% after a previously unknown research firm Gotham City Research LLC posted a lengthy report on Seeking Alpha, pillorying the company for its related party transactions, accounting statements and tax strategies, among other things.
The Gotham City website is as intriguing and opaque as Ebix’s financials are claimed to be. Little can be gleaned about the firm; the only known research report it has generated in its existence is the one targeting Ebix. The “About” section of the website states, “Gotham City Research LLC focuses on due diligence-based, special situation investing. As of the publication date of our articles, we may have long or short equity positions in the companies covered.” The sum total of Gotham’s work leaves little doubt that the firm is short Ebix shares.
GMI Ratings is in the business of assessing issuer risk within its global coverage universe by utilizing two main measurements – our ESG rating which measures Long- term Sustainability Risk and our AGR rating which measures Short-term Negative Event Risk. Ebix’s current ESG rating is a “C”, which reflects moderate sustainably risk, but not overly concerning. More instructive is Ebix’s current AGR rating of 5, which represents greater accounting and governance risk than 95 percentile of all companies in North America. The company has been rated as “Very Aggressive” since December 2009.
As the Herbalife drama has demonstrated in recent weeks, it does not pay for investors to step into the volatility cycle that typically follows the back and forth recriminations in a public spat. Moving away from Ebix’s stock price movement, there are a number of key takeaways elicited based on the AGR rating. Among the component metrics GMI flags within AGR is Ebix’s ratio of Operating Revenue to Operating Expense, which has been approximately 50% higher than the industry median for Software companies, placing it in the top 3% of the distribution for at least the last 3 years. The quality of Ebix’s assets is poor, with Goodwill representing a very high 65% of Total Assets, compared to an industry median of 18%. Intangibles are also considered to be high at 16% of Total Assets relative to an industry norm of 6%. Lastly, GMI flags the recent jump in both short-term and long-term Deferred Tax Assets relative to Operating Expenses. The increase suggests a possibility that adequate valuation allowances may not have been set up against these reserves and current period expenses may have been understated. The notion that Assets may be overstated is supported by significantly lower than median Revenues generated per dollar of Assets (Asset Turnover) that is also flagged as a risk element. A Barron’s blog entry covering the emerging Ebix story also echoed concerns that another Barron’s author had with the company’s tax practices back in July 2011.
Additionally, the GMI Litigation Risk Model projects the probability of shareholder class action litigation over various time horizons and also produces a score which represents the percentile rank of that probability. The model has indicated increasing concern since November 2012 when the score dropped from a 12 in November 2012, of to its current score of 2, meaning “High Risk.” This places Ebix in the 2nd percentile of all companies in North America, indicating higher shareholder class-action litigation risk than 98% of all rated companies.
The AGR rating measures forensic accounting risk – the risk that the public disclosures made by companies misrepresent actual results and are therefore not reliable for use in analysis. Though current AGR score of 5 does indicate very high forensic accounting risk, and the financial metrics mentioned above do align and provide some meat to the Gotham thesis, this data is not an open invitation to short a stock. Rather, AGR serves as a critical tool to help assess risks before material accounting issues do surface, and allows investors to screen out companies that exhibit troublesome characteristics.
Ebix states on its website that it is “A leading international supplier of On-Demand software and E-commerce services to the insurance industry.” Gotham City sets up the substance of its report by drawing a clear parallel between Ebix and other noted software accounting frauds such as Autonomy, Lernout & Hauspie, AremisSoft and Network Associates. Whether or not Gotham City’s extensive accusations of fraud have a similar outcome, investors who have had their eye on AGR, and simply avoided companies that are rated “Very Aggressive”, could have altogether side stepped the large hit that Ebix shares took on Thursday.