Category: Trading Strategy

I sold short a number of shares of eOn (Nasdaq: EONC) today, realizing $1176.40 in profits and retaining a 2000 share short position over night (I tried to sell short more shares on a spike but my main broker, Interactive Brokers, ran out of shares and the spike faded before I could short in my secondary brokerage account) . I initially shorted in response to a trade alert from Tim Sykes (sign up for TimAlerts here) although I re-shorted once I realized how good of a potential short EONC was. Sykes is one of the few day traders around who uses fundamental research as well as technical indicators to decide how to trade.

After Sykes shorted EONC because

this company is up 100% today on “positive” earnings on an apparent 50%+ increase in revenues…what they fail to mention is that that increase is only due to including revenues numbers from an acquisition and without it, revenues actually dropped because their products aren’t in great demand. Not to mention these “positive earnings” might get a lot of hype from today’s PR but they’re nothing new, here’s the SEC filing from a week ago where they talk about revenues

Quote excerpted from the alert Syks sent to his TimAlert subscribers. See his post about the trade.

This trade is a great example of how traders can benefit from understanding fundamentals … the company’s earnings press release was not actually news because the information in it had already been released in the 10-k (annual report) the company filed back on October 29th. Normally companies release earnings in press releases as soon as the data are available, maybe a week or so before the quarter’s results are sent to the SEC in a 10-Q or 10-K. Considering that the company’s results were available for over a week, why did the stock spike over 100% today when the earnings report hit the newswires?

The likely reason for the stock spiking today is that most traders do not read the SEC filings before deciding what to trade. They take a brief look at Yahoo! Finance and look at the news there. Earnings releases are usually new information (because they usually precede the SEC filings) so stock traders and individual investors all bought EONC today in response to the ‘good’ news. As they pushed the price up it showed up on the screens of momentum day-traders who then bought en masse, sending EONC up even more. Even though the press release today caused the stock rise, it was not new information, so the stock will likely dive in the coming days.

How is eOn doing?

eOn’s business involves VoIP and telephone routing products. After a quick glance at the company’s recently filed 10-K, I am glad I am short and not long.

eOn, while it was profitable in its most recent two quarters, has never been consistently profitable.

For the year ended July 31, 2009, eOn had a net loss of $339,000. eOn has incurred substantial losses since inception through July 31, 2009 resulting in an accumulated deficit of $48,856,000. eOn may not be able to achieve profitability from operations in the future.

eOn was also only profitable in the most recent quarters because of its acquisition of Cortelco. While it earned $111,000 in the most recent quarter, it would have lost money were it not for the Cortelco acquisition (Cortelco has earned $430,000 since being bought by eOn and it has only been 4 months since the deal closed).

Financial results for the current fiscal year include net income of $430,000 of Cortelco Systems Holding Corp., which was acquired on April 1, 2009.

While the earnings press release from today noted that:

Total year revenue increased 52% to $10,645,000 from $6,994,000 in fiscal year 2008.

This is due entirely to the Cortelco acquisition. Here the company describes revenues in the 10-K:

Net revenue increased approximately 52% to $10,645,000 for the year ended July 31, 2009 from $6,994,000 for the previous fiscal year. The increase reflects $4,231,000 in Cortelco revenue subsequent to the acquisition on April 1, 2009, partially offset by lower eQueue revenue from products, maintenance and professional services, and lower Millennium revenue compared to the prior year.

In actuality, were it not for the acquisition of Cortelco, eOn’s revenues would have decreased by 8%! But an 8% decrease does not sound as good as a 52% increase, so the company chose not to put the 8% figure in the press release.

Related party transactions

One thing an investor never wants to see is related-party transactions. These are always red flags, indicative of a company’s executives enriching themselves at shareholder expense. Related-party transactions also sometimes accompany fraud. Here are some of eOn’s related party transactions. All quotes are from the most recent 10-K unless otherwise noted.

Let’s start with the chairman of the board, who was also CEO and president until June 2008. Here is an interesting transaction between eOn and Symbio:

On August 1, 2007 and August 27, 2007, the Company made strategic investments in Symbio of $500,000 and $400,000 for 250,000 and 200,000 shares, respectively, or approximately 3% of Symbio. Symbio is a China-based provider of software development, testing, and globalization outsourcing services to multinational companies. The investment is expected to establish eOn as a preferred provider of telephony and contact center solutions for Symbio’s outsourcing engagements requiring customer interaction management. eOn also gains the ability to provide Symbio outsourcing services to its customer base. Symbio is a privately held entity and the Company accounts for its 3% investment by the cost method.

At the time of the second investment in Symbio for $400,000, the Company received a put option from David Lee, effective beginning January 1, 2008 and expiring January 1, 2011. The put option allows the Company to sell to David Lee a maximum aggregate of 200,000 shares of its investment in Symbio for a per share price of $2.00.

In consideration of the put option, in the event that the 200,000 shares are sold without exercise of the put option before January 1, 2011, the Company has agreed to pay David Lee 50% of the proceeds in excess of $1,000,000.

So Lee entered into a derivative contract with eOn hedging the value of Symbio’s shares. Here is a question for management: if Symbio is worth investing in, is it not worthwhile for the company to retain all the upside of the investment?

Lee was also the controlling shareholder in Cortelco, which was acquired by eOn back on April 1, 2009. Here are some details on that transaction, from the press release announcing it:

In exchange for all the outstanding shares of Cortelco stock, Cortelco shareholders will receive an initial aggregate payment of $500,000. All subsequent payments will be made to Cortelco stockholders quarterly in an amount based upon Cortelco’s quarterly earnings after closing, less $25,000 quarterly distributions made to eOn until eOn has received $500,000. Contingent primarily upon the level of Cortelco earnings after closing, all Cortelco stockholders are eligible to receive quarterly payments in cash until the full $11,000,000 consideration has been paid. David Lee, Chairman and CEO of eOn, is the Chairman and the controlling shareholder of Cortelco.

Whenever an executive of a public company sells a private company to the public company, shareholders in the public company need to ask who benefits from the deal. Such transactions are rife with conflicts of interest.

Auditor issues

eOn’s auditor, GHP Horwath, receieved criticism from the PCAOB.

The inspection team identified what it considered to be audit deficiencies. The deficiencies identified in one of the audits reviewed included a deficiency of such significance that it appeared to the inspection team that the Firm did not obtain sufficient competent evidential matter to support its opinion on the issuer’s financial statements. That deficiency was the failure to sufficiently evaluate the appropriateness of the issuer’s recognition and presentation of revenue from certain maintenance service contracts.

While that does not mean that eOn is doing anything wrong or that their auditor is incompetent, it is certainly a negative.

Aggressive accounting

The company also has a bit of aggressive accounting:

The Company capitalized approximately $243,000 of software development costs related to a new IP PBX that is under development.

Capitalization of software costs is both allowed and required, according to FASB Statement No. 86, but it can only be capitalized once it is feasible. It is still software industry practice to capitalize very few software development costs. Furthermore, there are slightly different standards for software that is to be included with hardware. Here is what the FASB stated:

The Board concluded that both establishing technological feasibility of the software component and completing research and development activities for the hardware component are necessary for capitalization of software costs to begin.

As eOn states in their 10-K that the “IP PBX that is under development,” it does not appear to me to be eligible for capitalization of the software developed to run it. When I run my own calculations on the results of a company in this situation, I correct for the aggressive accounting, de-capitalizing the amount spent and expensing it instead, which of course reduces the company’s book value and earnings.

Incentive Payments on Cortelco Acquisition

One thing I hate to see is when a company acts in such a way to increase current earnings and revenues at the expense of future earnings. This was the crucial problem I identified with the master franchise agreements that Noble Roman’s used (Boston Chicken also used those back in the 1990s to generate nice earnings before ultimately heading into bankruptcy). It is hard to find a business idea worse than master franchise agreements. That being said, I also dislike earn-outs in acquisitions. Companies that purchase a company and then pay based partly on the earnings on the purchased company over a period of time lose out on a significant portion of the upside (although these agreements do somewhat mitigate downside risk). The quarterly payments that eOn will make to the former owners of Cortelco are as follows (quotes from the merger agreement):

For the first 20 Quarterly Payouts, each Quarterly Payout shall be equal to the sum of (i) the Adjusted Cash Flow for the Quarterly Payout Period, plus (ii) 50% of the Pro Forma Net Tax Savings, minus (iii) $25,000, plus (iv) the Quarterly True-Up. All subsequent Quarterly Payouts shall be equal to the sum of (i) the Adjusted Cash Flow for the Quarterly Payout Period, plus (ii) 50% of the Pro Forma Net Tax Savings, plus (iii) the Quarterly True-Up.

This indicates that for at least five years (and continuing until Cortelco shareholders have been paid $11 million), the former owners of Cortelco will receive all the earnings of Cortelco and 50% of the tax savings from the merger. Shareholders of eOn will get comparatively little.

1.2 Adjusted Cash Flow. The earnings of the Surviving Entity after payment of all expenses associated with the Surviving Entity before tax as adjusted as set forth on Schedule 1.2 attached hereto, calculated in accordance with GAAP and Schedule 1.2 of this Agreement.

Conclusion

The only good thing I can say about the company is that it has plenty of cash ($3 million as of the most recent 10-K). It is also a tiny company, with a market capitalization using the closing price of its stock today of $8.32 million. Considering the aforementioned red flags, the company’s long history of losses, limited upside from the Cortelco acquisition, and a tangible book value of only $5.4 million, I would have no interest in buying EONC stock and I am glad I am short it.

Learn more …

Want to learn how to read SEC filings like I can? It can help you whether you are a fundamental investor, fundamental short seller, or a short-term trader who uses fundamentals along with technicals. Check out my 10+ hour DVD on the subject. It has 5 hours of me and 5 hours of Tim Sykes (get a feel for how he looks at companies by seeing his post on EONC), with each of us talking about how we look through filings. Read more about the money I have made by understanding SEC filings. The DVD will sell for $497 but is currently available for only $397 for those who pre-order.

Disclosure: Short 2000 shares of EONC. I may close this position at any time. The SEC filing DVD is being produced and sold by Tim Sykes’ company Bullship Press LLC and I will receive royalties on every sale. I will also receive a commission for every DVD bought through my affiliate link to Sykes’ web store. To see more details on my relationship with Sykes, please see my disclosures. I have a disclosure policy and you can find all mydisclaimers there as well; those disclosure & disclaimers are incorporated by reference into this post.