Here’s the 8K filing that led to today’s selloff:
On February 13, 2018, the Securities and Exchange Commission (the “SEC”) issued subpoenas to Ubiquiti Networks, Inc. (the “Company”) and certain of the Company’s officers requesting documents and information relating to a range of topics, including metrics relating to the Ubiquiti Community, accounting practices, financial information, auditors, international trade practices, and relationships with distributors and various other third parties. The Company is in the process of responding to the requests and intends to cooperate fully with the SEC.
This does sound similar to some of Left’s claims, so maybe the SEC is now getting around to investigating. It does seem somewhat far-fetched to believe that the SEC would be influenced by Citron, but it is difficult to know what is causing this with more information. Here is Bert’s reaction via a comment from his latest article:
This is no more and no less than an attempt by Left and his thugs to protect their short position. These are the same tired and false accusations that he and his cohorts made last fall. They were gross misrepresentations then and they still are. Just follow the cash. The company generated lots of it last quarter. And look at the community board and see how it works in terms of numbers. It is sad that this is the way the game is played these days and their is no sanction for getting the SEC to play the part of the heavy.
Although, UBNT has denied Left’s claims, they later did admit on 11/9 that the user community numbers from their investor presentation was misstated. See below from the 8K filing from that date:
As a result of a reporting error, the previously furnished Prior Investor Presentations and the investor presentation used by Company management dated as of May 2017 referenced 4 million registered users in the Ubiquiti Community, and the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2017 reported that the Ubiquiti Community included over 4 million entrepreneurial operators and systems integrators. In actuality, as of December 31, 2016, the Ubiquiti Community included approximately 609,000 registered users, while there were approximately 4 million registered user sessions at https://community.ubnt.com during the calendar year ended December 31, 2016. The information on https://community.ubnt.com is not part of this Current Report on Form 8-K.
This to me would appear to be more a result of the lack of G&A spend than an outright attempt to deceive investors. If your corporate operations are minimal, mistakes like this can sometimes get through. I am OK with this risk as long as there is a focus on making sure the financial reporting controls are decent.
The concern over accounting practices is unusual given the lack of complexity of their balance sheet. I have posted before how simple their balance sheet would be to audit and gain comfort over the balances. Note that from an audit standpoint, only the Q4 balances (June 30 year-end) would be audited in detail and for quarterly releases, KPMG would perform higher level procedures like flux analyses and review of critical items (major new contracts, accounting policy changes, etc). With that said, let’s go through the balance sheet:
Cash – $824M (71% of total assets) – From my 9/30 post “Cash is one of the easiest things to audit with the main test being an independent confirmation being sent out by KPMG directly to the bank. The bank would then complete the confirmation with the cash balance and send it back directly to KPMG. Given the direct confirmation, there is not much opportunity for the company to interfere if they were trying to fake a cash balance. In addition, given the high balance, KPMG, would likely test multiple controls around cash from a SOX perspective. The main control would be the reconciliation of the cash on the balance sheet to the bank statement. A UBNT accountant would need to perform the reconciliation and a separate supervisor would need to review it. There are likely multiple bank accounts, so there would be multiple cash reconciliations and multiple UBNT accountants involved in the reconciliation process. If the cash was a fraud, the company would need multiple people to be in on it, which is not likely. In addition, KPMG would reperform the cash reconciliations using bank statements that come directly from the bank. Given the large balance, KPMG would focus a lot of attention on the cash, so the risk of fraud around cash is close to zero. In addition, given that the debt is secured by the cash, the lender (Wells Fargo) would have done some work to verify the cash being used as collateral.” Since then Wells Fargo has increased their loan to UBNT, which they would not do if they felt there was a significant risk of non-collection.
Account receivable - $159M (14% of total assets) – For the year-end audit, KPMG would have sent out confirmations (similar to cash) to the major customers and have them confirm the balance owed. These confirmations would be sent back directly to KPMG. If there was a fraud related to inflating sales and accounts receivables, you would identify this pretty quickly because you would not be able to collect and would need to write off your receivables. Obviously, customers do not pay you unless they actually owe you the money. In addition, if they had a lot of write-offs, KPMG would require them to increase their allowance for doubtful provision account. So what is the provision you may ask. Only $461 as of 6/30 and $440 as of 12/31/17. Obviously not much risk here if they are reserving for less than $500…
Inventories - $99M (8% of total assets) – For the year-end, a physical inventory count would validate the quantities on the balance sheet. The physical would be attended by KPMG who would perform test counts. From a costing perspective, it is pretty easy to audit. There is no complex cost accounting to go through as they outsource the manufacturing. The cost is basically what they pay to the manufacturing vendor, which is quite easy to audit. The biggest risk from an audit standpoint is the excess & obsolescence allowance. Given how quickly UBNT reserved for the FrontRow inventory, they appear to be pretty quick to reserve against inventory and this is an area that KPMG would look at very closely.
Vendor deposits - $55M (5% of total assets) – I believe this would be prepaying the vendor for manufacturing costs. Some of this was already reserved against as some deposits related to FrontRow inventory manufacturing. From an audit standpoint, vendor deposits are quite easy to audit. You can trace the payments and confirm the balance at year-end.
So just like that we have covered 98% of the total assets. Note that property, plant and equipment makes up only 1% of total assets, so the risk of capitalizing expenses is not high given that you can’t hide much within an account that makes up 1% of your assets.
On the liabilities side, debt makes up $468M or 68% of total liabilities. This is really easy to audit as Wells Fargo is more than happy to confirm what UBNT owes them. Another $143M or 21% is made of taxes payable (mostly long-term). This is a little more complex, but KPMG will have their best tax people looking at this, so I am not concerned about the auditing risk here. The rest of the liabilities are made up of accounts payables and other current liabilities, which is generally pretty straightforward. If these were misstated, you would quickly see that as these liabilities would turn over pretty fast (they are mostly all classified as short-term).
From an audit perspective, the financials are quite easy to audit, so I don’t see much risk of material financial misstatement. In terms of typical audit risks, they are not overly significant here:
- Revenue recognition – I think this is pretty straightforward and no complex multiple elements arrangements here. They would just recognize revenue upon shipment to the customer. They have stated that the new rules (ASC 606) which go into effect Q1 2019 will not materially impact them. That would be mostly due to the fact that there are no complexities.
- Inventory costing – I discussed this above, but typical manufacturing companies have complex costing where you have to estimate the costs by part, which includes material, labor and overhead. Since UBNT buys from the manufacturer, they would just use the price paid to them as their inventory costs.
- Capitalizing expenses – This is where WorldCom focused their fraud. They were able to increase their reported income by capitalizing expenses (turning expenses into depreciable assets). Given the simplicity of their balance sheet, UBNT would have difficulty hiding these types of expenses especially since they don’t manufacture their inventory.
- Goodwill – This is a very judgmental area as it is difficult to value this. Luckily for us, UBNT has no goodwill since they don’t make acquisitions.
KPMG knows their reputation is on the line. They wouldn’t sign off on the year-end financials unless they covered their themselves. They obviously know what happened to Arthur Andersen and the $1.435M audit fee is not enough for them to take on any risk of PCAOB findings through a sloppy audit. I live in the SOX world and I know the PCAOB keeps the Big 4 partners up at night, so they will dot all their i’s and cross their t’s.
The strongest proof for me that UBNT is not a fraud is Pera’s ownership. Although he sold 1M share last year (related to being ready for any action coming out of the Grizzlies buyout clause), he has not sold any additional shares. He owns 56.3M shares, which makes up 72.4% of the company. In addition, the company has been eagerly buying back shares. Pera takes no pay from the company, so his gain is through equity appreciation. If you were running a fraud, wouldn’t you sell off your shares as fast as you could without causing the stock price to crash?
I bought some Jan 2020 $50 calls today and will be looking to buy more if shares don’t rally over the next week.