C3 Stock Falls on Accounting Challenges

It’s not simply individuals who make irresponsible funding choices that imagine shorting must be made unlawful. Even His Holiness Elon Musk has been vocal about eager to “go after the Wall St short-sellers,” his feud with Invoice Gates allegedly surrounding a big Tesla brief place. Irrespective of how unhealthy an organization seems to be, we by no means brief shares as a result of the irrationality of the meme inventory varieties will at all times outlast our margin limits. In truth, we discover brief reviews to be the last word bear case metal man that we will use to guage lengthy positions.

We beforehand identified how AI hype was driving the value of C3 (AI) together with different AI-labeled shares like SoundHound (SOUN) and the last word AI pick-and-shovel play, NVIDIA (NVDA). The joy appears to have began in late January of this 12 months, a cut-off date at which C3 traded round $12 a share. Nothing has occurred over the previous a number of months to benefit the rocketing share value, so we have now each motive to imagine the intrinsic worth of C3 stays roughly the identical – the vary of $12 a share that it was buying and selling at earlier than the hype hit.

Shares ought to return from whence they got here, roughly $12 per share, or virtually 60% under present ranges. The corporate’s excessive mixture of decrease margin skilled providers, challenged development, and business worst money circulate profile suggests the draw back could possibly be even higher.

Credit score: Kerrisdale Capital

The Kerrisdale Brief Report

On March sixth, Kerrisdale Capital – “a research-oriented funding agency” – printed a 27-page brief report that rightly identified how shares of C3 benefited tremendously from the hype round generative AI. It additionally probed different considerations, some beforehand raised in a February 22 brief report by Spruce Level Capital Administration that largely surrounded C3’s largest buyer, Baker Hughes, which additionally occurs to be a associated get together. Yesterday’s 26% drop in share value for C3 resulted from a 7-page letter despatched to C3’s accounting agency, Deloite, with a duplicate despatched to the SEC. Stated letter raised the next factors of competition:

• Development in unbilled receivables
• Complicated financials associated to a associated get together and C3’s largest buyer, Baker Hughes
• Inflated gross revenue margins that end result from COGS being incorrectly labeled as R&D
• Classification of income as subscription income when it’s truly providers
• Vital turnover in CFOs who’re more and more much less certified

This aggressive escalation is understandably unnerving buyers who proceed to dump shares in aftermarket. It shouldn’t be a shock to see shares sink again all the way down to ranges seen earlier than AI hype, and this letter is barely accelerating that reversion to the imply. The timing of the letter coincides with C3’s fiscal 12 months ending on April 30, and Kerrisdale has requested Deloitte to evaluation their considerations in anticipation of its upcoming work conducting the corporate’s year-end audit. Let’s take a look at the factors of competition raised within the letter, beginning with a essential character within the story – Baker Hughes (BKR).

Baker Hughes and C3

With a market cap of $30 billion and 2022 revenues of $21 billion, Baker Hughes is without doubt one of the world’s largest oil discipline providers corporations. They’re additionally the second largest shareholder in C3 holding 8.65 million shares or about 8% of the corporate. (That’s after they offered roughly 2.2 million C3 AI Shares at round $66 a share in 2021.) The 2 corporations established a three way partnership in 2019 and the ensuing relationship has been tough to explain at finest.

The letter’s first concern surrounds the expansion in unbilled receivables which is primarily as a result of one buyer – Baker Hughes – who just isn’t being billed for revenues which have already been acknowledged. SYMPAQ tells us that “when unbilled receivables happen, it’s as a result of they can’t be billed but below the phrases of a contract,” and, “sadly, auditors view unbilled A/R with scrutiny.” Kerrisdale states the issue succinctly:

Within the final 4 quarters, C3.ai has apparently acknowledged $80m of receivables (from a associated get together shareholder, no much less) in an quantity that’s equal to virtually 30% of whole company-wide income throughout that very same interval, for which it has not even invoiced.

Credit score: Kerrisdale Capital

Baker Hughes just isn’t solely C3’s second-biggest shareholder, but additionally chargeable for a 3rd of whole revenues. Consequently, they’ll be receiving favored therapy throughout contract negotiations. This downside is definitely rectified if Baker Hughes begins being billed for the work being carried out and pays these payments. If C3 is certainly “utilizing extremely aggressive accounting to be able to meet sell-side analyst estimates,” then working with their second largest shareholder to resolve this downside must be a straightforward repair. However the a lot greater downside to resolve right here can be correctly articulating the connection between the 2 events. A number of the verbiage at present used to explain the connection is not possible to decipher, and consequently considered with suspicion. Kerrisdale factors to revenues from Baker Hughes that aren’t being recorded with an accompanying cost of goods soutdated (COGS) which artificially inflates C3’s gross margin.

The Gross Margin Drawback

Software program corporations with recurring software program gross sales and excessive gross margins can rightly deserve excessive multiples, as working bills will be simply ratcheted down. However within the case of C3.ai, we imagine they’ll’t be.

Credit score: Kerrisdale Capital

Gross margin is one indicator we take a look at on the subject of the survivability of any enterprise. When instances get robust, profitability will be shortly achieved by reducing prices. The upper the gross margin, the better it’s to attain profitability. Accounting techniques make sure that COGS is accurately allotted such that gross margin will be accurately calculated. If an organization chooses to maneuver COGS into one other bucket, say R&D, then they’d have a deceptively excessive gross margin. Final quarter, C3 spent as practically as a lot on R&D as subscription revenues acquired – about $55 million – which additionally occurs to be the quantity of shares-based compensation (SBC) they paid out (sometimes within the tech business, SBC would common round 23% of whole revenues, a quantity thought-about excessive by historic requirements)

We imagine that C3.ai is hiding prices inside analysis and growth bills that must be labeled as prices of income.

Credit score: Kerrisdale Capital

The implication is that C3 isn’t providing a scalable software-as-a–service (SaaS) answer, however relatively an answer that requires an excessive amount of handbook intervention. Regardless that they classify revenues into two buckets – subscription {and professional} providers – C3 describes their subscription label as “stand-ready COE assist providers” and “upkeep and assist providers.” All of the confusion across the Baker Hughes relationship doesn’t assist right here.

The implication is that providers aren’t scalable, and C3 shouldn’t command a SaaS premium if providers account for a higher proportion of revenues than what they’re stating under.

Skilled providers are “sometimes a fixed-fee engagement with outlined deliverables and a period of lower than 12 months.” Onboarding new clients can be a traditional instance {of professional} providers, so the quantity must be declining over time as seen above – except, in fact, it’s being incorrectly said.

All of the factors of competition raised thus far encompass alleged accounting irregularities, and the icing on Kerrisdale’s cake is the excessive degree of CFO turnover seen at C3 – 4 totally different chief monetary officers over the past 4 years – every with a lowering quantity {of professional} expertise. The implication is that no competent CFO would threat ruining their status by getting concerned with an organization that’s fudging their numbers.

Our Tackle C3

Brief reviews should be taken with a grain of salt, however two consecutive brief reviews are regarding as they largely encompass factors of competition that we discover to be crimson flags as effectively – buyer focus threat and associated get together revenues. The non permanent drop in share value isn’t a priority as a result of it was massively inflated to start with. What’s regarding is the letter despatched to 3rd events about accounting irregularities. With the SEC in copy, Deloitte has now introduced of their authorized group and moved to CYA mode. It’s possible their ideas might be made clear after we see how the year-end filings would possibly change to elucidate what the brief agency views as deficiencies. They’ll in all probability take on a regular basis they should conduct due diligence earlier than signing off on C3’s yearly monetary statements. C3 can say no matter they need nevertheless it’s Deloitte who we’re watching.

Deloitte doesn’t must rubber stamp fraudulent accounting. Both require the corporate to come back clear in its upcoming audit or resign and let C3.ai administration sully the status of a lesser audit agency.

Credit score: Kerrisdale Capital letter to Deloitte

As for C3, they made a bog-standard assertion to CNBC about how “the Kerrisdale Letter seems to be a extremely artistic and clear try by a self-acclaimed brief vendor to brief the inventory, publish an inflammatory letter to maneuver the inventory value downward, then cowl the brief and pocket the earnings.” To be truthful, Kerrisdale is right to name out the rise in C3 shares ensuing from the generative AI hype. The excellent news is that if Deloitte finds no fault in how C3 has been doing their monetary reporting, then it’s a nonevent, and Kerrisdale’s unique brief accusations will lose credibility. We’re not essentially satisfied that’s the case, however we’re not right here to take a position. Ought to Deloitte discover issues with C3’s accounting, shares are going to fall an entire lot additional than they did yesterday.

Conclusion

A second brief report adopted by an accusatory letter to one of many world’s largest accounting corporations with the SEC in copy is unhealthy sufficient. Couple that with a share value that’s been pumped up over 100% due to generative AI hype and let the volatility start. Shares of C3 must be anticipated to reach on the value vary they have been buying and selling at previous to all of the hype. The bottom fact might be in what Deloitte finally ends up signing off on for C3’s Fiscal 2023 outcomes. We don’t count on a lot colour till that occurs. As for our personal holding, we’re not taking any motion till we hear from Deloitte, a agency that’s more likely to conduct a number of due diligence earlier than arriving at a conclusion. This example underscores the significance of avoiding associated get together revenues and excessive buyer focus threat when investing in disruptive tech corporations.

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