Deep Dive into AudioEye
Board: Saul's Investing Discussions
So I spent some of my weekend reading AEYE’s latest 10-Q, 10-K and some other information I could find (because what beats spending a summer weekend reading SEC filings, right?). Anyone that has invested in the company, or is considering an investment in the company, I strongly encourage you to at least read the company’s latest quarterly 10-Q report.
It’s only 22 pages long. The 2nd quarter 10-Q should be released in another two weeks.
If you’re investing a couple percent of your portfolio, you should probably familiarize yourself with the additional info in the 2013 Annual 10-K report. It is a lot longer, but much of the information gets repeated a few times and you can scan over it after reading it the first time.
OK, so let’s get to it,
“Holy red flags, Batman!”
is essentially what I said to myself about 10 minutes in as I decided whether to sell two-thirds, or all, of my current position in AEYE after reading this in Footnote 1 of the 3/31/14 10-Q (note I later changed my mind about selling right now as you'll see below):
For the three months ended March 31, 2014, the Company sold one license for cash of $225,000 and exchanged the same license to three other customers for licenses to their intellectual property. The three licenses exhanged were determined to meet the aforementioned criteria and were each recognized as revenue and intangible assets for $225,000 each for a total of $675,000.
So what we’re saying here, is that of the $1.029 million record quarterly revenue they recognized in Q1, only about a third of that, or $350k, was sold for cash. The other $675k was essentially traded for licenses to the customer’s IP (of which I couldn’t easily figure out what those obtained licenses were, although I didn’t look too hard. It does look like they are a 3 year license based on the amortization period of the related intangible assets) and AEYE will never actually be paid for the $675k of Q1 sales. This is allowed under GAAP accounting rules, but there are a lot of hurdles you have to overcome to record revenue this way, which I’ll assume that AEYE had covered.
Theoretically (and hopefully for shareholders) the licenses they obtained will somehow lead to future revenue, but I don’t know the details. There were probably press releases when those sales occurred (as AEYE LOVES to issue PR’s, not sure I think that is necessarily a good thing or not) which may explain more but I haven’t dug in that far just yet.
My first thought was “ok, so if 2/3rds of their Q1 revenue represents sales that they’ll never be paid for, what if 2/3rds of the $3 million Q2 revenue they pre-announced is also non-cash sales?”. Well the first answer to that question, is, that would be a very bad sign. The second answer is, we need to wait until they announce Q2 (last year it was announced on August 9th, I assume the timing will be similar, maybe the 8th if they keep it on a Friday again) because the pre-announcement didn’t specify.
The good news is that the pre-announcement did specify:
Approximately $1 million in contracts were secured with leading national health care companies.
I would find it unlikely that they were trading licenses for IP of a health care company, so I’m assuming that, at least that $1 m of the $3m Q2 revenue was sold for cash.
The first thing I’m going to be looking at when Q2 is filed will be whether there was any of this non-cash revenue, and if so, how much? At the moment I’m thinking that $1m or more will make me very nervous. Hopefully the Q1 $675k was the exception rather than the rule and hopefully they will be able to utilize the licenses they received in lieu of cash payment to generate some real (cash) revenue in the future.
The next thing that has me nervous is “where the heck did the increase in Accounts Receivable come from in Q1 if only $350k of their Q1 revenue is going to be paid in cash?!?!”
12/31/13 AR was $569k, and 3/31/14 AR was $1,295k, an increase of $726k. But if there were only $350k of revenue in Q1 that has cash coming and would create new AR, then that would suggest that they did not collect any of the $569k of AR from 12/31 during Q1 AND there is another mysterious $400k of new AR that has appeared on the balance sheet unrelated to any new revenue??? There has to be an explanation, but I can’t come up with one. Anyone with any ideas, let me know, but I’m sending this question to the company’s investor relations and see what they tell me. I'm betting it has something to do with exercises of equity instruments or something like that but we shall see.
I also couldn't find any disclosure of typical payment terms (60 days, 90 days, etc) even in the large 10-K which leads me to believe that they either vary significantly from agreement to agreement or they are generally not specified in their agreements (which would be bad so hopefully that isn’t the case).
The discussions on this board about whether a new equity raise will be needed shouldn’t be immediately dismissed simply because revenue is high…we need to know how much of that revenue actually relates to future cash receipts. The good news is that much of the $1.6m of G&A expenses in Q1 were also non-cash, meaning that the company doesn’t need to come up with the cash to pay for these expenses each quarter. $850k of that related to stock, option, and warranty non-cash expense, as per the next section below.
So I took a deep breath, realized that there’s nothing I can do with my shares until Monday at the earliest, and kept reading….
The D Word
Dilution, that is. There’s going to be a lot of it with this small company that wants to grow fast but doesn’t have much cash to spend. At Dec 31, 2012 there were 35.2 million common shares outstanding. At Dec 31, 2013, that grew to 52.2 million shares. And up to 55.4 million at Mar 31, 2014. There is another 8.7 million options outstanding at 3/31 (I believe mostly issued to employees) with an avg exercise price of 41 cents and another 19.5 million warrants outstanding at 3/31 with an avg exercise price of 38 cents (mostly issued when they were raising cash in recent past years). Assuming the stock price stays at $1 or more (a big IF), this will be another 27 million shares or 50% or so dilution that is pretty much guaranteed to take place. Granted, this also would be about $7 million of much needed cash paid to the company to exercise the warrants (I’m assuming that the options can, and probably would be cashlessly exercised, net).
Some of these options and warrants won't vest for a few years, but many of them will vest in the next year or two. However the ones that will generate more income cash from exercising them will likely be the later ones which doesn't help with the current cash situation.
Now with any company like this, you’re going to find them wanting to pay for whatever they can with stock until significant cash flows start rolling in. I believe Facebook did lots of this early on (not that I want to suggest that AEYE should be compared to FB in any way).
This shouldn't be a surprise, but if the company continues to grow at really high clips like they have recently AND collects cash timely from those sales, then we can live with really high dilution from a young fast growing company like this, but it is definitely something to keep an eye on.
It seems like management has a lot of their financial interests tied to the company’s stock price. The CEO receives a $200k annual salary, which seems modest as far as CEO base salaries go, although I bet that buys a lot in Arizona, where AEYE is based. In 2011, he had loaned about $1 million to the company. He was also owed about $400k in unpaid salary by the end of 2012. He elected to have all of that debt converted into common stock at 25 cents per share. Now that seems cheap today given the current stock price, but at the time, in late 2012, that was the fair value of the shares, so instead of trying to raise money have the company pay him back in cash, he was willing to covert over a million dollars into company stock and accept the same risks of other shareholders, similar to if he bought the shares on the open market. This tells me that he believes that the company will be successful in the future and isn’t trying to just pull whatever cash out of the company that he can to line his pockets in the short term. Obviously this has already paid off handsomely for him by quadrupling his money if he were to sell those shares today at $1 each, but there’s no sign that he plans to sell shares right now. I could definitely be reading this wrong, but this is one of the main things that has convinced me not to sell any of my shares just yet, at least until I see the Q2 report.
Other Random Items Noted
They mention that their current office lease is for $13k/month, but 2013 rent expense was only $39k (about $3k/month on average), which tells me they took over a lot more space at the very end of 2013 and are expecting to need a lot more room for a lot more employees. This matches up with their comments that the G&A expense has increased with new hiring. Hopefully that will continue to translate to big new sales and a growing top (and bottom) line.
I found it interesting that they mention the timing to be issued patents. The first one they mention was applied for 2003 and not issued until 2010. Another was filed in 2007 and issued in 2011. Not sure how meaningful this is but I found it interesting
They found in 2013 that the company’s “internal control over financial reporting was not effective in providing reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles due to the presence of the following material weakness - Material inconsistencies and omissions related to financial reporting related to certain equity transactions” This is not good. They do go on to say that the remedied this in the first quarter of 2014 and don’t expect it to be an issue going forward. Regardless, it is concerning.
A lot has been said about the US gov’t mandate that governmental websites be usable for persons with disabilities but nowhere, including in AEYE’s filings have I found any deadlines. This mandate was passed in 2010 so it doesn’t seem like they’re in any big hurry and I’d say it is unlikely there will be much in terms of penalties for divisions that are lax to comply.
Can’t find any online reviews of AudioEye – I tried searching online and couldn’t find anything. I guess Yelp isn’t using AudioEye yet.
That's it for now. I tend to have a pretty high risk tolerance when it comes to my investments and this is possibly the riskiest company I've ever put my money in. I think we're going to learn a lot really quickly when the Q2 announcement comes out, regarding the quality of the $3 m of revenue, and their ability to collect on their sales.