UBNT - Citron's focus on cash

I think most UBNT investors think that Citron moved on after their initial September 18 short report on the company. Right before investor day, Citron issued a seeking alpha article that listed 10 questions that they wanted the company to address (https://seekingalpha.com/article/4109414-questions-ubiquitis…). The questions were more researched than the initial short report and would almost make you think that they were no longer calling UBNT a fraud, except that 4 of the 10 questions related to cash. They also tweeted the following:

$UBNT @RobertPera @ScottWapnerCNBC Investor day tom Let’s get answers for these 10 questions. http://citronresearch.com . Fake cash is Fraud

https://twitter.com/CitronResearch/status/912342274406735872…

I still think that Citron covered on the day they issued the short report and they are trying to make it seem that they are not letting down so there is less damage to their reputation and to help the follow on shorts that blindly followed them into shorting UBNT.

We can see that short interest actually came down a lot after the Q4 earnings was announced in early August and the pop in the stock of 25% was partially helped with short covering as we can see shares short went down from 8M shares on 7/31 to 6.8M shares on 8/15. The short volume then started to go back up and as of 9/15 (right before the Citron report was released), the short interest went back up to 7.5M. I imagine a good part of the increase of 700K shares short was related to Citron going short before they issued their report. See short data here: http://www.nasdaq.com/symbol/ubnt/short-interest

It will be interesting to see how many shares are short as of the end of September, which we should find out soon. However, poster Curioustock
on UBNT’s StockTwits board posted that shorts are paying a very high interest rate to short shares right now:

$UBNT Almost 15% borrowing rate now. Well done shorts! You’ve almost tripled the rate since Citron’s BS hit piece

This means that most likely a lot of people followed Citron into shorting UBNT given that the borrowing rate to short UBNT is so high. To me this means there are a lot of people shorting UBNT that do not really understand the company and still believe that there is fraud.

As I mentioned in my other post (http://discussion.fool.com/why-i-bought-more-ubnt-32844489.aspx), I am very confident that there is no fraud due to KPMG issuing a clean opinion on the recently released 10K:

UBNT is a much larger company that paid their external auditor (PwC) $1.8M in fiscal 2015 and $2.1M in fiscal 2016. For a Big 4 auditor, a $200 per hour blended rate is typical, so for fiscal 2016, PwC would have incurred around 10,500 hours for the SOX and the financial audit. Also, the external auditor has full access to all the accounting records, Board minutes, accounting personnel, management, etc. For audit engagements, Big 4 firms don’t sell anything other than their seal of approval and they are audited every year by the PCAOB, so they need to make sure they audit extensively and document all their testing because they will be audited sooner or later and they don’t want too many black marks from the PCAOB. See https://pcaobus.org/Standards/Auditing/Pages/AS1215.aspxfor the audit documentation standards that the auditors are held to. This isn’t the pre-SOX days where you could get away with not fully understanding the business and controls like what happened with Enron. In the SOX world, the PCAOB will review the external auditor’s workpapers to verify they fully documented according to the standards. Also, the PCAOB performs their audits based on risk, so you better believe that KPMG (the fiscal 2017 external auditor) was fully expecting a PCAOB audit and dotted every i and crossed every t when it came to the UBNT audit.

I am pretty sure that due to the material weaknesses found in previous years, PwC tried to jack up the audit fee for fiscal 2017 knowing that they would have to increase their audit hours in preparation of getting scrutinized by the PCAOB. This is likely the reason they switched to KPMG. KPMG isn’t cheap either so I assume that the 2017 audit fee will be at least as much is the 2016 $2.1M fee. We will find out the 2017 audit fee once UBNT files their proxy in December. Knowing that KPMG gave UBNT a clean audit and that the previous material misstatements were remediated in 2017, I have no doubt that there are no material misstatements or material fraud. I know this because I work closely with my company’s external auditor and my team performs SOX control testing in order for management to sign their 302 SOX certification (http://www.soxlaw.com/s302.htm). Pera and the CAO sign the 302 certification as well making them personally liable if a material fraud is later found out. So who do you believe: KPMG who had over 10,000 hours of trained auditors go over UBNT’s accounting records or Andrew Left who has no audit background and no access to company records in addition to having done very little research into UBNT (based on some of the easily refutable claims he made)? I’ll go with the external auditor charging $200 per hours with full access to company personnel and records. No external auditor wants to be the next Arthur Andersen and KPMG knows that their UBNT audit workpapers will likely be closely dissected by the PCAOB. Left does not need to prove anything. He just shorts the stock, posts a report that has many glaring holes, goes on CNBC crying fraud and makes millions with no external government agency scrutinizing his claims.

Citron’s new post does focus on cash, which make sense from their standpoint. UBNT’s business is pretty simple from an audit standpoint. They outsource all the manufacturing, so no complex costing to worry about and not a lot of machinery & equipment. In fact, when you look at their balance sheet, their total $972M in assets are made up of $604M (62%) in cash. They also have $141M in receivables owed by customers and $142M in inventory. On the liabilities side, debt makes up $256M out of $371M. As an auditor, this balance sheet would be very easy to audit. Given the very low fixed asset balance of $13M, there is very little risk of the fraud that took down Worldcom where they capitalized expenses and moved them to fixed assets. This made them look more profitable and delayed expense recognition. UBNT’s balance sheet is so simple, there is no good place to hide any fraud. $12M in fixed assets is tiny and would not be a good place to hide expenses for a company projecting sales of over $1 billion this fiscal year.

Given the simplicity of the balance sheet, Citron targets the only thing they really can, which is the big $604M cash balance. Most of this is stuck outside of the US, which means that the company would need to borrow against it to buy back stock as they do not want to pay repatriation tax. This has caused UBNT to borrow $256M using the foreign cash as collateral. This debt will likely go up when they report the Q1 financials given the additional $150M in authorized buybacks approved on September 5 and 18.

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.

I am frankly surprised that the audit fees are so high given the simplicity of the balance sheet and this is likely driven by the previous material weaknesses. Now that they have gotten a clean audit opinion, UBNT can likely start to negotiate lower fees in the future. Citron’s focus on cash fraud is not very well thought out from an audit standpoint given the ease of confirming cash balances. UBNT’s balance sheet is just too plain and boring to be able to hide material accounting fraud. Fraud would be easier to hide in complex balance sheets that use fancy derivatives (see Enron) or high capitalized expenses (see Worldcom). As investors in UBNT, accounting fraud risk is pretty low.

As time goes by, I imagine the shorts that followed Citron will lose their patience as no fraud is exposed and eventually cover. This should put upward pressure on the stock.

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Wouter,

What a fantastic series of posts on UBNT you’ve shared with us. Thank you! I increased my position in UBNT almost immediately after the short attack and drop because the article was so flawed and transparent as to what it was. But your detailed viewpoint from an accounting side is amazing. Definitely helps with the confidence in the position. So thank you once again.

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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. … 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… Citron’s focus on cash fraud is not very well thought out from an audit standpoint given the ease of confirming cash balances

This is simply not true. Faking cash is easy and happens all the time in frauds.

http://www.nytimes.com/2011/05/27/business/27norris.html

'Deloitte, which had given clean audit opinions to Longtop for six consecutive years, apparently was well on its way to providing a seventh, for the fiscal year that ended March 31. But for some reason — Deloitte did not say why —the auditor went back to Longtop’s banks last week to again seek confirmation of cash balances.

It appears Deloitte sought confirmations from bank headquarters, rather than the local branches that had previously verified that Longtop’s cash really was on deposit…

Goldman Sachs was not the underwriter of ShengdaTech, a Chinese chemical company traded on Nasdaq, but its investment arm, Goldman Sachs Investment Management, had accumulated a 7.6 percent stake in the company before its auditor, KPMG, refused to sign off on the company’s 2010 annual report and then resigned in late April. KPMG cited “serious discrepancies” regarding bank balances and “discrepancies between KPMG’s direct calls to customers and confirmations returned by mail.” Just as at Longtop, it appeared that auditors had been given false confirmation letters.’

If it’s not a fraud, and I’m not saying it is, there is definitely corporate misbehavior in having no CFO and only earning ~20bps on your giant cash balance when you can easily earn 1% in no-risk, instant liquidity US Treasuries.

No position in UBNT.

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This is simply not true. Faking cash is easy and happens all the time in frauds.

http://www.nytimes.com/2011/05/27/business/27norris.html

'Deloitte, which had given clean audit opinions to Longtop for six consecutive years, apparently was well on its way to providing a seventh, for the fiscal year that ended March 31. But for some reason — Deloitte did not say why —the auditor went back to Longtop’s banks last week to again seek confirmation of cash balances.

It appears Deloitte sought confirmations from bank headquarters, rather than the local branches that had previously verified that Longtop’s cash really was on deposit…
Goldman Sachs was not the underwriter of ShengdaTech, a Chinese chemical company traded on Nasdaq, but its investment arm, Goldman Sachs Investment Management, had accumulated a 7.6 percent stake in the company before its auditor, KPMG, refused to sign off on the company’s 2010 annual report and then resigned in late April. KPMG cited “serious discrepancies” regarding bank balances and “discrepancies between KPMG’s direct calls to customers and confirmations returned by mail.” Just as at Longtop, it appeared that auditors had been given false confirmation letters.’

As you know Longtop and ShengdaTech are both Chinese companies, so comparing their audits to an American based UBNT’s audit is like comparing apples and oranges. The audit industry in China is still a little immature as you can see here:

The rules provide that any firm that has two disciplinary actions within two years must face a suspension. RSM and BDO are the second and third largest accounting firms in China, trailing only PwC. Because the Big Four firms audit few locally listed companies, they are unlikely to trip the two-action wire, while RSM and BDO audit about 1,000 A-share listed companies each and therefore would seem to be at great risk of tripping the wire.

The January ban came during the audit season, causing the firms to lose many clients.
I have a mixed view on these actions. First, I think they are a good thing, reflecting that China is taking audit quality seriously. Audit quality is essential to the orderly development of China’s capital markets. On the other hand, I think the penalty is too severe and may hurt the development of the profession. I fear the short-term result may slow the development of the capital markets.

The CPA profession in China is young, and is currently entering its third phase of development. The first stage, infancy, began with the reemergence of the profession in 1980 and continued through the separation of CPA firms from the state about 1999. The second stage, adolescence, saw the firms grow into sizable, but clumsy teenagers. The largest firms now have over 10,000 accountants and have contributed significantly to the development of China. We are now beginning the third stage where the firms enter adulthood. As adults, regulators are now holding the firms to task for their responsibilities as independent auditors essential to the integrity of capital markets.

I understand that many of the problems are coming from the lightly regulated National Equities and Exchange Quotation, commonly known as China’s Third Board. There are thousands of small companies listed on this board, which was created to allow small private companies access to capital. I believe this board has rampant accounting fraud, yet it has been tolerated by regulators who dealt with the risk by limiting access to the market to wealthy investors. I expected that someday regulators would clean up this market, probably by getting tough on auditors, and it appears that day has arrived.

The CPA firms need to respond to these actions by focusing on quality instead of growth. Client acceptance processes need to be tightened, and internal quality review processes strengthened. The culture of the firms needs to change, shifting the focus from winning new clients and growing quickly to doing a better job auditing and managing risk. The firms are going to have to learn to say no more often. That will be a painful shift, and some accounting firm partners are unlikely to be able to make the change. Those partners will need to find a new profession, because this one needs umbrella holders, not rainmakers.

http://www.chinaaccountingblog.com/weblog/chinese-audit-regu…

Paul Gillis PhD is a CPA and professor in China and an expert on the external audit environment in China. China has restricted access for the PCAOB to perform audits over the CPA firms that audit Chinese based companies. China is trying to make the Big 4 firms hand over control to Chinese partners:

The struggle between local Chinese and the Big Four accounting firms has been going on since the return of public accounting to China in the early 1980s. China let the Big Eight firms set up representative offices beginning in 1980, and in 1992 allowed the Big Six to enter joint ventures with state controlled firms. About 2000, all CPA firms including the Big Four were separated from the state. In 2012, China required the required the Big Four to begin the transfer of the firms from expatriate partners to local Chinese partners.

As a CPA and auditor myself, I will tell you that the quality of audits performed by US and European auditors is far higher than auditors in Asia. I have poked many holes in the findings of certain Asia based auditors. In my role, I work very closely with our Big 4 external auditor here in the US and the level of testing and documentation performed is very detailed and rigorous. This is much different from audit quality I have seen outside of Europe and North America.

You are also comparing UBNT’s audit to an audit fraud that happened in 2011. Comparing audit procedures to 2011 to today is like comparing night and day. Please talk to an experienced Big 4 SOX auditor and they can tell you stories on how PCAOB requirements have become much more stringent in the last few years. Take a look at IPE (information produced by the entity) controls in 2011 vs 2017. The Big 4 auditors beat IPE to death today, while in 2011, they barely considered IPE. Comparing audit procedures from 2011 to 2017 is a very bad comparison. Comparing audit procedures in China in 2011 to US audit procedures in 2017 is bordering on incompetence.

I don’t know much about Longtop, but I would wager a lot of money that UBNT’s balance sheet is much easier to audit. Given that over 60% of UBNT’s balance sheet was in cash, that there is no manufacturing to audit (it is all outsourced), there were previous material weaknesses around cash (wire fraud) and that the audit fees are around $2 million, KPMG would spend a lot of time auditing cash.

If it’s not a fraud, and I’m not saying it is, there is definitely corporate misbehavior in having no CFO and only earning ~20bps on your giant cash balance when you can easily earn 1% in no-risk, instant liquidity US Treasuries.

The money is outside the US and cannot easily be invested in US Treasuries (US rates are higher than many parts of the world). Plus the money is being used as collateral for loans to buy back stock in the US, so there is likely to be restrictions on how the cash can be invested. Until recently, a lot of foreign government bonds were selling at negative interest rates. I suppose if they really focused on it, they could maybe increase the interest paid on this cash by a fraction of a percent, but Pera has his focus on designing the products that will increase revenue significantly. From my standpoint, this is a much better area to focus on.

For me, I am happy with a CAO whose focus is on accounting and internal controls. CFOs are typically not accountants and not CPAs. CFOs focus on meeting wall street analysts, M&A, refinancing, investor presentations, etc. UBNT is a company run by engineers that don’t try to please Wall street analysts. Paying an experienced CFO millions of dollars and giving away stock options would more than offset any increase in interest income, so I am fine with them not having a CFO.

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